Rising rupee poses tough policy choices.

The rise of the rupee vis-a-vis the dollar is likely to sustain, hurting exports and raising the danger of higher inflation or higher interest rates as the RBI tries to rein in the rupee by buying up dollars. The measures that were actively debated prior to the onset of the financial crisis, to discourage excess inflows, such as putting a ban on participatory notes of foreign institutional investors, need to be put in place without wasting time.

On Thursday the rupee rose to its highest in more than a year, closing at Rs 46.34 to the dollar, a gain of over 3% in just four sessions. Though it pared some of those gains on Friday, the broad trend is likely to be of rupee appreciation vis-à-vis the dollar. This is an inevitable corollary to the influx of dollars into an economy whose absorptive capacity has not kept pace with its needs, combined with a weakening dollar.

Appreciation of the rupee hurts exporters by making Indian exports less competitive vis-à-vis exports from other countries. To the extent the rupee strength is due to the dollar’s weakness causing many other currencies also to appreciate, Indian exports might not be hit too hard. But a significant part of the appreciation is due to dollar inflows, both direct and portfolio, and this is India-specific.

In-bound foreign direct investment has touched $9.5 billion in the first quarter of the current fiscal, more than the amount received in the previous six months while portfolio flows that were negative last year have turned hugely positive ($12.8 billion in the calendar year to date).

At a time when exports have declined for the 11th consecutive month (though the pace of decline has moderated) and there is evidence of job losses and human distress in export centres, a rising rupee would do more damage. Unfortunately, any steps to mitigate this disaster — the RBI buying dollars and pumping in rupees — could well be an invitation to a bigger problem.

It would add to money supply at a time when there is already surplus liquidity and aggravate inflationary pressures. The solution is for the RBI to go back to its tight-rope walking: balancing inflation and the exchange rate.