This article was originally titled 'High domestic demand bedevils Indian rupee.' But noting that a weak rupee can be employed as a reflationary tool in the current economic environment (for instance, its potential to reduce the slack in our export industries such as textiles), the title was changed to bring in that perspective.

Indeed, this is the battle - between a weak rupee's potential to boost export demand on the one hand and the damage it could cause on account of the already high domestic demand - which appears to be taking place in Indian policy making circles in recent times.

The battle so far seems to be going the way of those who prefer a weak rupee as an export supporting tool and more broadly even a reflationary tool for domestic import-competing industries. As a reflationary tool for domestic industries, a weak(ening) rupee works in two ways: one, it provides greater pricing power for domestic industry as the landed cost of imports becomes dearer with the rupee's progressive depreciation. Second, and in a more strategic sense, the domestic economy (more specifically domestic demand) is shielded from the high(er) interest rates which will be inevitable if the rupee is to be defended. Looked at in this perspective, it appears that Indian policy makers have decided to have the rupee take a knock in the foreign exchange markets while seeking to protect domestic demand.

The Indian currency, consequently, has been under severe downward pressure in the domestic foreign exchange markets. While it managed to hold its own around the 39-40 levels against the dollar in the initial months after foreign capital flows turned negative early in 2008, it has since lost close to 25 per cent of its value. Perilously close to the 50 level (which was even briefly breached in December 2008) against the US currency as at the time of writing this piece (18 February), the Indian rupee's has been the second worst performance among Asian currencies in the past year - after the 35 per cent loss in South Korea's won.

Rupee's prospects hinge on capital flows

So, what lies ahead for the rupee? Will it lose further value in an environment marked by continued risk aversion to emerging market investments? What could be the consequences of such further value loss for the overall macro economy? Will Indian policy makers reverse their present policy stance and more vigorously defend the rupee - which, in turn, implies taking more active steps to cool domestic demand?

Given the policy slant for a weak rupee as an export supportive and overall reflationary tool, it does seem like the rupee is in for an extended period of weakness. Rupee weakness seems to be assured if the overall global risk aversion towards emerging market economies does not abate in the ensuing period. Foreign capital flows - comprising portfolio, FDI and external commercial borrowings - will continue to be weak in that scenario.

A unique feature about the Indian currency is that it is a capital flows-driven currency. Even though India's trade deficits have been increasing sharply in the past five years - from a level of just around a billion dollar per month in 2003 to $10 billion plus every month now in 2008-09 - the overall current account of the balance of payments has broadly been under control on the back of the increasing levels of services exports (software, BPO) as well as the private remittances from overseas Indians. The net financing requirement on account of the trade in goods and services (called the current account deficit) therefore has been quite marginal - at around 1 to 1.5 per cent of GDP even as the economy expanded strongly in the past five years.

Therefore, if capital account flows are in excess of the 1.5 to 2 per cent of GDP, the impact is felt right away on the rupee's exchange rate as it appreciates on the back of excess dollar inflows. In this scenario, the only countervailing force to the rupee's appreciation is the Reserve Bank of India's market intervention operations to buy the excess dollars and thereby prevent too high and rapid appreciation of the rupee.

A study of the developments in the rupee, RBI's intervention operations, level of capital flows, and level of the current account deficit over the past decade clearly shows the above state of affairs. The surplus in the capital account of the balance of payments (BoP) which was modest around 2 to 2.5 per cent of GDP in the earlier part of this decade, rose sharply from 2004-05, rising to as much as nine per cent of GDP in 2007-08.

Inflation danger from weak rupee and rising trade deficit

The trade deficit, though, has to be looked at in isolation when capital flows dry up as has happened since January 2008. A slowdown on the services front (software, BPO and other services) only makes it more imperative to monitor the trade deficit closely.

The rising trade deficit then becomes a potent inflation danger. At the macro level, a rising trade deficit shows that the underlying level of consumption and investment demand in the economy is very strong. It is just that instead of domestic supply, such high demand is being satisfied by overseas supply. The inflationary consequences of such high demand are suppressed when the rupee is strong. But when the rupee turns weak, continued high (and rising) trade deficits and the underlying high demand it reflects can potentially trigger a resurgence of inflation if such demand pressures are transferred to the local economy. (It is true that some of the demand pressures cannot be transmitted on to the local economy - for instance, oil demand - since there is not enough local supply, imports are the main source of supply and imports can benefit from the steep fall in the international price of oil. But it is also a fact that non-oil imports have continued to increase significantly despite a falling rupee. These non-oil imports represent the latent, or rather suppressed, level of demand in the economy and can severely strain domestic supply if it hits the local economy).

In the event, it is quite possible that the weak rupee does not merely provide beneficial spin-offs as a reflationary tool for the domestic economy. It could go one step higher and have fairly adverse consequences in the form of a resurgence of inflationary pressures.

As always, the underlying cause of any resurgence in inflation has to be addressed. That, in turn, will automatically take care of the rupee also, slowing down or minimising its losses. The underlying cause is the high level of demand in the economy which gets reflected in the rising trade deficit. Moderating overall demand in the economy calls for possibly a higher level of interest rates. If done preemptively, such interest rate hikes could be phased out in a controlled manner. If not, there is the risk that policy makers are forced to retract on their current easy money (and soft interest rates) stance in a disruptive manner.