Diamonds glitter. But not for those who cut and polish them. Reason: over the last year, the rupee has firmed up by as much as 10 per cent against the dollar. "Our margins are under 2-3 per cent and the currency movements have cost us dear as we realise lower returns for the same goods," says Praveen Nanavati, a diamond trader in Surat, Gujarat. A few hundred kilometres north-west of Surat, the story is quite different. Reliance Industries' 33-million-tonne Jamnagar refinery, which exports over 70 per cent of its products, is hardly affected. "Reliance is naturally hedged due to large capital projects in hand as well as the higher purchasing power of domestic consumers," says P.M.S. Prasad, CEO (oil and gas business), Reliance Industries (RIL).

The Class Divide

The petroleum business scores over the diamond trade for more reasons than one. It overtook the diamond business to claim the pole position in India's export basket around two years ago. But more importantly, it highlights the 'currency divide'. While large firms such as Reliance Industries are able to ride the currency shocks, smaller firms are left in the lurch. "Few exporters are allowed by their bankers to hedge exports proceeds against a rising rupee," says Ganesh K. Gupta, President, Federation of Indian Export Organisations (FIEO), which represents around two-thirds of the exporting companies.

Size matters in this regard. Bajaj Auto, with an annual turnover of around Rs 8,500 crore, has hedged between 30-50 per cent of its annual exports. Says U.R. Bhatt, a financial advisor, "Hedging against a currency is an expensive affair if the deal size is not large."

The reason is not far to see. Reserve Bank of India (RBI), the regulator of foreign exchange controls in the country, has been conservative in letting go of controls on capital flows into the country-only RBI authorised banks are allowed to issue hedge instruments. Hence, the hedge price is discovered in an inter-play between the few selected banks, rather than on an exchange where the number of players are far more, thereby facilitating a better price discovery. "So, if you are shopping for a hedge for, say, a $200,000 export order, it could cost you 0.5-1 per cent. Compare this with the stock exchanges, where stocks are traded at a charge of between 0.05 to 0.1 per cent," says Bhatt. Not surprisingly, some of the worst hit exporters are in the diamond trade, notwithstanding the fact that they enjoy a natural hedge-the raw material is entirely imported.

Balancing Act

The pace of liberalisation, however, gained momentum early this month, when RBI announced its annual monetary policy. The policy allows for greater capital flows out of the country-automatic approval for early prepayment of external commercial borrowings of up to $400 million (Rs 1,640 crore). "The day before yesterday's volatility is today's flexibility," said RBI governor Y.V. Reddy, after presenting the policy.

But, clearly, volatility has a lot to do with the RBI's actions itself. Says Ajay Shah, a former advisor to Finance Ministry: "RBI's move to suddenly allow the rupee to appreciate after having spent more than $19 billion (Rs 77,900 crore) over the four months ended February 2007 in stemming its rise underlines the unpredictablity of the monetary policy."

This shift in strategy caught the exporters, who were used to RBI calming the rupee, totally unawares. With an estimated 70 per cent of exports denominated in dollars, RBI is clearly to blame for their plight as they were not forewarned.

Governor Y.V. Reddy: Getting his act together

While RBI appears to be attempting a soft landing for the rupee-by exposing it to the forces of demand and supply-the collateral damage is extensive (exports are hit, while cheaper imports could injure domestic industry) in the absence of financial instruments to soften the blow.

While the issue of capital controls simmers, inflation control continues to be RBI's prime objective. Inflation, measured by the rise in the wholesale price index, reached a peak of 6.7 per cent before calming to a little over 6 per cent. But not before RBI affected interest rate hikes on five occasions in an attempt to curb liquidity and, consequently, the purchasing power of consumers. On the other hand, it purchased dollars from the market (to stem a rising rupee, and thus ensure competitiveness of exports) and drained the rupees by getting the government to issue securities (else, excess liquidity will drive up inflation). This comes at a price: Rs 2,500 crore for soaking up the rupees released into the market during the four months ended February 2007. Furthermore, the interest rate on the government bonds has risen by 55 basis points to 7.89 per cent during fiscal 2006-07, as investor appetite for the bonds is on the wane.

While this increases the financial burden on the exchequer, there is obviously a limit beyond which priorities are reflected. A recent proposal by RBI to seek an open-ended account to 'sterilise' the rupee using government securities was turned down by the Finance Ministry. Its argument: while inflation affects all of us, a strong rupee affects only exporters. Hence, protecting the interest of the exporter at any cost (repeated purchase of dollars and its consequent sterilisation to avoid excess liquidity) is not acceptable.

On its part, late last month, the Finance Ministry decided to intervene and apply filters on the flow of capital into the country-preferential shares will be treated as external commercial borrowings (debt) and not as equity. The reclassification was more than academic in nature-it signalled to the market the government's intent to review the quality of capital entering the country (See The Rising Tide). And, typically, debt would be the first in the line of fire. Here's why: While raising debt overseas is a cheaper option for several credible corporates, it would, for a good part, involve immediate conversion into rupees-which, in turn, would stoke inflation. "For the moment, ECBs upto $500 million (Rs 2,050 crore) do not require government approval. The government is, however, studying various options. We are, however, well aware of the possibility of a negative investment sentiment in the event that capital flow controls are re-introduced," says a senior finance ministry official. Adds Yogesh Mathur, CFO, Moser Baer India: "ECBs are certainly attractive and constitute around 20-30 per cent of our total borrowings. Hence, any restrictions on this count will impact our cost of borrowings."

P. Chidambaram: Inflation is a concern, but what about exports?

While the state is busy debating incremental measures to curb inflation and control the rupee exchange rate, the forces of globalisation have already seeped deep into the country's economy. And, what better measure than the two-way capital flows, which is as much as 67 per cent of the GDP.

The Holy Trinity

Past experience often decisively shapes the future outlook of not only individuals but also institutions-the balance of payment crisis in 1990-91, when the country did not have foreign exchange reserves to pay for even a week's imports certainly shaped RBI's conservative approach to capital controls. "At present, however, we can support 18 months of imports and hence, RBI can surely accelerate the pace of capital flow liberalisation," says U.R. Bhatt.

Easing the barriers quickly will help for other reasons too. The State is in the grips of a policy limitation in the monetary domain-theoretically, it cannot control the holy trinity-inflation, domestic interest rates and capital flows. It has already partially let go of one-capital flows, with RBI playing the main doorkeeper, monitoring FII inflows into the country. Surely, the need of the hour is to embrace globalisation, in a manner that industry does not get hurt. And for that, RBI will need to loosen up its regulations and allow financial instruments like derivatives and bond markets to thrive.

Evidently, the exporters are justified in seeking currency props only to the extent of absence of reforms that impede their ability to work on their costs and produce the same goods at lower prices. "Policy makers have to ensure that real sector (labour, infrastructure) reforms precede financial sector reforms for Indian industry to benefit from globalisation," says Shankar Acharya, former Chief Economic Advisor, Ministry of Finance. And, therein lies a key test of governance.

-additional reporting by Aman Malik