India's strong rupee is an enviable problem to have, according to the Economist Intelligence Unit:
In some ways, the present strength of the currency, which is now hovering just above the symbolic Rs40:US$1 mark, is an enviable problem. It suggests that the country's attractiveness to foreign investors is increasing and signals optimism about the Indian economy more generally.
...the rupee's appreciation has benefited the economy by making imports cheaper. This is no small benefit--containing inflation has been high on the policy agenda during the past year, as the annual inflation rate (as measured by the point-to-point change in wholesale prices) rose to 6.1% in January 2007, compared with 4.2% a year ago. The inflation rate has subsequently moderated. This may offer the RBI some comfort in its battle against inflation, but the bank's new, stricter inflation target (4.5-5% in 2007/08, down from 5-5.5% in 2006/07) suggests that there will be one more increase in interest rates by the end of 2007.
Why is the currency so strong?
The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange inflows, especially US dollars. The surge of capital and other inflows into India has taken a variety of forms, ranging from foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slacken.
But it's not all good news:
However, the rupee's appreciation is alarming exporters, as it makes their products more expensive in overseas markets and erodes their international competitiveness.
The RBI's deputy governor, Rakesh Mohan, recently referred to the effects of the rupee's appreciation as a case of "Dutch disease". The term refers to episodes where large inflows of foreign exchange—usually as a result of the discovery of natural resources or massive foreign investment—leads to appreciation of the currency, undermining a country's traditional export industries. ("Dutch disease" originally referred to the adverse impact of the discovery of natural-gas deposits in the Netherlands on that country's manufacturing exports.)
There is already evidence in India of an export downturn in a number of sub-sectors. In the apparel sector—one of India's major export industries--the strong currency has eaten into the value of exports to the US, which declined by 3.5% year on year in January-April 2007. During the same period, apparel exports to the US by China, India's most important competitor, rose by 57%. Moreover, for India the decline marks the reversal of a positive trend—apparel exports to the US rose at an average rate of 21% a year after import quotas were phased out at the beginning of 2005.
...policymakers cannot afford to ignore the problems of exporters. Although exports account for a relatively small share of the economy, India's rapid export growth in recent years has been an important catalyst of economic growth. Given the limited extent to which the RBI can intervene in the foreign-exchange market in the face of large and sustained capital inflows, policymakers can only stem rupee appreciation substantially by easing limits on domestic firms' overseas investments or restricting inflows--for instance, through further controls on ECBs. The RBI has already taken tentative steps in this direction, making it more difficult for Indian firms to borrow in foreign currency and eliminating the exemption from ECB limits previously enjoyed by real-estate firms.