Indian Rupee Appreciation – Short Term Gain, Long Term Pain

Indian Rupee Appreciation and its effect on controlling inflation: On October 31, 2006, 45.25 Indian
Rupees equalled one US Dollar but one year later, it has already appreciated by 14.7% and 39.46 Indian
Rupees equals one US Dollar. On the positive side, this appreciation has benefited the Indian economy
by making imports cheaper, especially crude oil where India imports approximately three-fourths of its
requirements. In fact, even though the price of crude oil has surpassed US $97 per barrel, the rate of
inflation as measured by the wholesale price index in India, which was 6.1% in January 2007, has
already dropped to 3.4% – the lowest such figure during the last five years. This is by no means a small
feat especially in a country where most people live on less than $3 per day, and for many, a higher
inflation implies not even having two good meals in a day!

On the other hand, as discussed below, this appreciation is likely to cause significant harm not only to
Indian exporters but also to the Indian economy in the long run especially because most of this
appreciation is occurring not due to a trade surplus but rather due to large in-flows of foreign exchange
that can reverse itself quickly, thereby, depreciating the Indian Rupee and causing massive inflation.

Detrimental Effect on Exports: Rupee appreciation is already impacting the profit margins and pricing for many Indian exporters because

• The cost of labour and raw material is usually in Indian Rupees whereas more than 80% of sales
  contracts signed by Indian exporters are in US Dollars.
• The Chinese Yuan, Pakistani Rupee, South Korean Won, and Bangladeshi Taka have only
  appreciated by 1% to 5% during the last year, thereby, making the products and services
  exported from these countries more competitive.
• Even though the Euro, the Canadian Dollar, and the British Pound have also appreciated by
  11.7%, 14.2%, and 7.8% respectively within the last year, because the Chinese, Pakistani, South
  Korean, Bangladeshi and Sri Lankan currencies have not appreciated as much as the Indian
  Rupee, the Indian exports have become less competitive in these regions also.

Since, nearly two-thirds of India’s exports come from Indian SMEs (Small and Medium Enterprises)
who have thin margins anyway, because of the increased costs in India (but not in other countries),
clearly some of these SMEs will go bankrupt. In fact, since traditional exports (in textiles, chemicals,
gems and jewellery) are labour intensive, according to the Federation of Indian Export Organisations
(FIEO) around 350,000 people have lost jobs during the last few months and another 450,000 are likely
to lose during the next few. Below, we briefly describe some sectors that are getting particularly hurt
because of this appreciation:

• The sectors worst hit include textiles, apparel and leather, and these constitute 15% – 16% of the
  total exports from India. During October 31, 2006 – October 31, 2007, the Chinese Yuan has
  appreciated by 5.4%, Pakistani Rupee almost none, and the Sri Lankan Rupee has actually
  depreciated by 4.6%. So, it is not surprising that during January – April 2007, on a year-on-year
  basis, apparel exports to the US by China — India’s most important competitor – rose by more than
  50% whereas those from India declined by 3.5%. This is particularly disturbing because this decline
  ends the sharp growth in this sector that started after import quotas were phased out at the beginning
  of 2005. Since there is always a lag in these sectors, the full impact of this appreciation will
  probably not be visible until February – March 2008. In this regard, FIEO has recently stated that
  these Indian exporters were “hardly signing new contracts” because of uncertainty on the foreign
  exchange front.
• In the case of steel also, Indian exports compete with those from China and South Korea and since
  the currencies in these countries only appreciated by 5% – 5.4% during the last year and since price
  is one of the biggest deciding factors for the buyers, Indian exports are beginning to lose ground
  here also. The same is true for the chemical, petrochemical and generic pharmaceutical sectors
  where Indian exporters compete with those from China, South Korea and Eastern Europe.
• According to Mr. Sunil Mittal, the president of CII (Confederation of Indian Industry), in the
  automobile sector, stocks have piled up during the first half of this year in an increase of 18.7%.
  Similarly, according to the numbers released on October 7, 2007 that are related to the Index of
  Industrial Production (IIP), the industrial output rate of the consumer durables sector declined by
  6.2% as compared to a positive growth of 19% in August 2006, and the automobiles figures are a
  part of the consumer durable basket in this IIP estimate.
• Since the Information Technology (IT) and IT Enabled Services (including the Business Process
  Outsourcing) industry derives more than two-thirds of its revenue in US Dollars, most Indian
  companies in this sector would have their net profits before taxes reduced by 6% by the end of
  March 2008. Finally, since the Chinese Yuan and Eastern European currencies have not appreciated
  substantially, these countries are likely to become more formidable competitors in the IT and ITES
  sectors also.

Export revenues for July 2007 stood only at $12.4 billion, up from $10.5 billion in July 2006. In fact,
exports during the months of July and August 2007 registered a growth of 18% as compared to 41% a
year ago. Similarly, the growth rate during April-June 2007 also stood at 18% in contrast to 32% during
the same period last year. That number is significantly short of the Indian government’s target of 28%
export growth to achieve $160 billion during the fiscal year 2008. In fact, according to Evalueserve’s
analysis, the worse is yet to come: since there is a time lag of 6 to 9 months in exports whenever Indian
Rupee appreciates or depreciates with respect to the US Dollar, our forecasts show that Indian exports

would only total $144 billion during the fiscal year 2008, thereby increasing by only 15% on a year-on-
basis and falling 10% short of the desired goal of $160 billion and driving the trade deficit to more than

US $40 billion (i.e., approximately 4% of India’s GDP during April 1, 2007 – March 31, 2008).

Increase in Current Account Deficit: What ever goes up very fast must come down: Unfortunately, the
main reason for Rupee’s appreciation since October 2006 has not been due to India’s trade surplus with
other countries. Indeed, if India had a trade surplus with the rest of the world, such an appreciation
would have been justifiable. The reality is that actually India has a trade deficit that has already
increased by 63% from US$ 19.9 billion during the same period a year ago to US$ 32.5 billion. Clearly,
this trade deficit would affect directly India’s current account deficit, which according to the Reserve
Bank of India (RBI), already had a shortfall of US$ 4.69 billion during April-June 30 2007 as compared
to a surplus of US$ 2.56 billion in the previous quarter. According to Evalueserve’s estimates, this
current account deficit is likely to be US $5.4 billion during July – September 2007, $6.2 billion during
October – December 2007, and $7.1 billion during January – April 2008, thereby resulting in a net
current account deficit of approximately $23.4 billion during this fiscal year.

Unlike the Chinese Yuan, the Indian Rupee is relatively “free floating.” Hence, the surge in Indian
Rupee appreciation is being caused by enormous in-flow of foreign exchange, especially from Foreign
Institutional Investment (FII), Foreign Direct Investment (FDI), and short-tem as well as long-term
deposits sent by Persons of India Origin (PIOs). Unfortunately, recent history – especially that during
1994 and 2003 (e.g., Mexican Crisis of 1994, Asian Crisis of 1997, Argentine Crisis of 2001) – is
replete with situations where this money exited faster than it entered a given emerging country or
region. Indeed, when this money exited, it also left behind substantial destruction with the
corresponding currency depreciating by 20% or more, thereby, causing massive inflation. Finally, even
though some pundits claim that “this time it’s different,” it seems to us that history seems to be
repeating itself and unless the Indian Rupee stabilizes around 43 Rupees to a US Dollar soon, the Indian
economy may be in for some tough times in the near future.