In recent days the RBI is being increasingly censured, for the monetary tightening measures in the recent past, and especially its decision to let the Rupee appreciate, in its fight against inflation. In a country where 260 million people are below the poverty line, and fighting a daily battle for bare survival, burdening them with an inflation rate of over 6 percent can not be acceptable. High inflation rate is neither good for growth or equity.
In this situation the RBI is bound to take measures to bring inflation rates down to manageable levels. It has tried to do so by raising the short term rates and reserve ratios as well as letting the nominal exchange rate appreciate. The first two measures have been aimed at reducing the liquidity in the economy with an objective of curbing demand. On the other hand appreciation of the rupee reduces the price of imports, which lowers the overall price level. Moreover, by refraining from intervening in the forex market and allowing the Rupee to move freely, the RBI also keeps liquidity under control, which again helps in fighting inflation.
It has been argued that the appreciation of the rupee is bound to hurt the Indian exports and consequently put brakes on the high growth rate of the Indian economy. What is being ignored is that a large number of Indian exports like electronic hardware, petroleum and gems and jewellery are import intensive and are benefited from the appreciation of the Rupee in so far as cost of production is lowered. A related point is that export competitiveness of a country depends upon the real exchange rate and not the nominal exchange rate. The real exchange rate between two countries depends on the inflation differential between countries apart from the nominal exchange rate. Thus if other countries are experiencing low inflation than India, their cost of production is going to be low, which in any case is going to make Indian exports uncompetitive. Figure 1 below shows that although REER index has increased somewhat from August 2006, its value in March 2007 is similar to what it was a year ago.