Thursday, June 28, 2007

Answers to some shout-box queries – 6

On 20th June Sridhar was asking me about how Dutch Disease raises exchange rate. What is the process behind the rise or decline of exchange rates. A few months back the $ rate was around Rs. 45. Now it has declined to about Rs. 40. How does it depend on the economy?

Dutch disease doesn’t lead to a rising rupee. A rising rupee leads to the Dutch disease. The rise of the rupee will make the country’s exports uncompetitive. When there is more demand for the local currency, its price will go up with reference to a foreign currency. If people holding dollars want more rupees, then the rupee will appreciate against the dollar. (I have put it in a very simplistic way. It may be good enough to understand the concept.) There will be many factors beyond a mere ‘demand’ which will determine the price of the rupee vs the dollar. Yes, a few months back, the rupee was hovering around Rs. 45 a dollar, but today it is hovering around Rs. 40 a dollar. That means that our currency is strengthening against the dollar. We do not have any classic reason – an excessive natural resource find – to explain the strengthening. It arose out of the steady increase of foreign investment inflows into the country. International investors seem to believe in the India growth story. That is why they are pouring in dollars. Hence the rupee is rising. That ‘belief’ of international investors is a thing which depends on how our economy is performing. They are deriving confidence that as the country’s economy is growing, any investment made in the country, will surely yield better returns than elsewhere. The policies of the country will allow them to repatriate profits or that there won’t be any need to repatriate profits in the immediate future.