Reserve Bank of India (RBI) governor Y V Reddy today disputed the notion that there is an inverse relation between the movement of the rupee and the direction of prices. The rupee’s rise to nine-year highs will not necessarily bring inflation down, he pointed out.

Explaining his contention, the RBI governor said that a rising rupee increases import demand by making foreign goods cheaper. Given that the Indian economy is now on a high growth trajectory — with the growth rate almost touching double digits — the elasticity of import demand with respect to import prices is very high.

Thus, a small fall in prices of goods imported would lead to a high increase in imports. This means that even a small rise in the exchange rate of the rupee — and corresponding fall in prices of dollar-denominated goods — might lead to a sharp rise in export demand. The positive effect that this would have on inflation might very well offset any negative effect that a rising rupee otherwise triggers, leading to net positive effect on the inflation rate.

Asked why the central bank had let the rupee rise sharply after buying $19.7 billion through intervention to help stem its gains, Reddy replied, “The day before yesterday’s volatility is today’s flexibility.”

“In some ways the effect of the currency appreciation is to make imported goods cheaper,” Reddy said, but there is a risk of this spurring demand. “If the demand goes up, is it going to solve your inflation problem?” he asked.

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