Let the rupee soar

The sharp rise in wholesale price index based inflation to 6.68 per cent, no doubt, calls for a response from the government. A high level cabinet committee is to meet today to decide its response. It is important that the government analyse the causes of inflation before proposing a response. Last year too, about the same time, inflation had risen sharply. This was brought down by an increase in interest rates. But last year, inflation was demand driven and the rate hike helped in cooling down the overheated Indian economy. Growth slowed down, as expected, and price rise was contained. This year8217;s inflation is different. It is coming at a time when the economy is slowing down. The strategy to reduce inflation cannot be based on reducing growth further. This year8217;s inflation is primarily the result of a supply shock coming from rising world commodity, food and oil prices. It would be a mistake to raise interest rates to deal with this kind of inflation. Growth would slow down further and, given that inflation is due to higher global prices, it may not be significantly contained.

The best way to deal with international price inflation affecting the Indian economy would be a strong rupee. The exchange rate pass-through from a change in the rupee-dollar rate to domestic inflation is positive. In other words, when the rupee appreciates it reduces the price of imported goods or import parity priced goods, that is, goods whose prices are determined by world prices. This will help in pulling down prices. Instead of quantitative restrictions such as a ban on exports of food products whose world price is high, a strong rupee will ensure that it is less profitable to export these items. This will help make more food available domestically. Also, it will make it cheaper to import food and food products. The government should, in addition, eliminate import duties on edible oil, for example, to make it more affordable. The combination of a strong rupee and the removal of duty will make food products cheaper. It will also eliminate incentives to hoard.

One of the most serious policy mistakes made by the UPA government over the last year was to prevent the Indian consumer from benefiting from a strong rupee. The political power of exporters appears to have forced the government to resist rupee appreciation. Since rupee appreciation comes at the cost of higher domestic prices, today, the government is paying this price. Hopefully, now that we are closer to an election, the interest of the larger mass of the population may rule over the interest of a concentrated group of exporters.