The Indian Rupee-US Dollar Exchange Rate: The Economic Impact

of a Strengthening Currency

"The

profitability of exporters has been wiped out and constant appreciation is

threatening the competitiveness of our product. If we lose the market, aggressive
competitors are just sitting on the fence to occupy the market." 1
- G.K. Gupta, President of the Federation of Indian Export Organizations
(FIEO),2 in October 2007
"The government is concerned over the rapid appreciation of the rupee against the
US dollar and the central bank may have to intervene if there is disorderly movement
in the exchange rate."3
- P Chidambaram, Finance Minister of India, in September, 2007
"The objective of the exchange rate management has been to ensure that the
external value of the rupee is realistic and credible as evidenced by a sustainable
current account deficit and manageable foreign exchange situation. Subject to this
predominant objective, the exchange rate policy is guided by the need to reduce
excess volatility, prevent the emergence of destabilizing speculation activities, help
maintain adequate level of reserves, and develop an orderly foreign exchange
market."4
- RBI's Policy in the Foreign Exchange Market
Introduction
In April 2007, on the back of a rising rupee, the Indian economy became a trillion
dollar5 -economy, moving the country into an elite group of nations (Refer Exhibit I
for the List of Trillion Dollar Economies). By August 31, 2007, the Indian currency
was trading at 40.96 against the dollar, as compared to 46.55 on August 31, 2006,
an appreciation of around 12 percent (Refer Exhibit II for Rupee-Dollar Exchange
Rate
Movement
from
August
2006
to
August
2007).
The rise in the value of the rupee was a result of the general weakening of the dollar
in international markets, plus India's growing attractiveness to foreign investors.
In 2006-07, India attracted huge capital inflows in terms of foreign direct investment
(FDI),6and foreign institutional investment (FII).7 External commercial borrowings
(ECB)8 and non-resident Indian (NRI) deposits and remittances also contributed to
the dollar inflow.

The Indian Rupee-US Dollar Exchange Rate: The Economic Impact of a

Strengthening Although India had been witnessing strong dollar inflows for some
time, the rupee had not appreciated as steeply as it did between September 2006
and July 2007 mainly because on earlier occasions, strong dollar inflows into India
usually saw the Reserve Bank of India (RBI)9, India's central bank, intervene in the
foreign exchange market and purchase excess dollars so as to minimize volatility in
the value of the rupee.
This time around, the RBI chose not to intervene, in order to keep domestic inflation,
which had been hovering around 6 percent in early 2007, in check. While the RBI
and the finance ministry were able to tame the inflation rate (inflation fell to 3.52% in
August, 2007), the rupee's appreciation affected Indian exporters as Indian goods
became
more
expensive
for
foreign
buyers.
Information technology (IT) and textiles industries were particularly hard-hit, as they
were
the
most
dependent
on
the
US.
Leather, sugar, and plantation crops were some of the other sectors that were
starting to lose competitiveness. The Indian Micro, Small and Medium Enterprises
(MSMEs) were also affected. It was feared that falling export competitiveness would
cause substantial job losses...
Background Note
In India, the RBI had always played an active role in the foreign exchange market.
However, since the country faced a severe balance of payments (BOP) crisis in the
early 1990s, there was a greater understanding of the importance of the rupee-dollar
exchange
rate
on
the
economy.
With reserves down to only around $ 1 billion in mid-1991, caused partly due to a fall
in exports and also due to a decline in remittances (following the Gulf war), the
country
was
close
to
defaulting
on
its
debt
repayments.
The Indian government then negotiated with the IMF for SDR of around $ 2 billion to
stave off any external debt crisis...
Reasons Behind the Appreciation of the Rupee in 2006-07
Toward the end of 2006, foreign exchange inflows, especially of dollars, into India
started rising sharply. This put upward pressure on the rupee's exchange rate
against the dollar. India's steady economic growth offered several opportunities for
foreign companies. Between April 2006 and March 2007, FDI of $ 16 billion flowed in
to India...
Effects on The Economy

The rupee's appreciation against the dollar was seen to be beneficial to the Indian
economy in some ways, and detrimental in other ways. The rise in the value of rupee
meant that inflation was curbed. The inflation rate in India declined from 6.73 percent
in February 2007 to 4.10 percent in August 2007...
Some Perspectives
The 'trilemma' or the 'impossible trinity' as economists sometimes called the
management of exchange rate, interest rate, and inflation rate, has always posed
problems for central banks the world over; and the RBI was not an exception...
Outlook
In June, 2007, the Economist Intelligence Unit estimated that for the year 2007, the
rupee's average annual exchange rate against the dollar would be 41.3 (a 13.5
percent real appreciation year on year), and for the year 2008, it would be 40 (6
percent)...

Case Study Questions:1) Explain the reasons for the rapid appreciation of rupee in 2006-2007.
2) Explain the impact of rupee appreciation on the economy.
3) Critically analyze the role of the central bank in the foreign exchange
market.
Answer of Case Study Questions:Ans:- 1In 2006-2007, India experienced rapid appreciation of its currency against the

US dollar. The reasons for the appreciation of the rupee were a generally weak
dollar in international currency markets and sharp increase in dollar inflows into the
country, partly due to India's increasing attractiveness to foreign investors . Between
April 2006 and March 2007, FDI of $ 16 billion flowed in to India...
Ans:-2 The rise in the value of rupee meant that inflation was curbed. The inflation
rate in India declined from 6.73 percent in February 2007 to 4.10 percent in August
2007. the rupee's appreciation affected Indian exporters as Indian goods became
more expensive for foreign buyers. Information technology (IT) and textiles industries
were particularly hard-hit, as they were the most dependent on the US.
Leather, sugar, and plantation crops were some of the other sectors that were
starting to lose competitiveness. The Indian Micro, Small and Medium Enterprises
(MSMEs) were also affected. It was feared that falling export competitiveness would
cause
substantial
job
losses

Ans:-3 India's central bank, intervene in the foreign exchange market and purchase
excess dollars so as to minimize volatility in the value of the rupee. This time around,
the RBI chose not to intervene, in order to keep domestic inflation, which had been
hovering around 6 percent in early 2007.