The exchange rate problem. Since October 2006, the rupee has gained around 10 per cent on the back of large inflows into the capital account. Mukul G. Asher, professor, State University of Singapore, explains: "Asian countries such as China are not allowing their currencies to adjust (against the dollar) and creating negative externalities for others like India."

That is, these countries are keeping their currencies weak, creating a trade deficit in the US. The dollar has been weakening against most major currencies. Over the last month alone, it lost about 4.50 per cent against the rupee. This has helped companies importing raw materials or capital goods, but is likely to hit employment and growth in the long term.

This has also put the RBI in a spot. If it wants to keep the rupee weak, it will have to put rupees back into the economy to buy dollars. But that will offset some of the reduction in liquidity it had managed by raising the PLR and cash reserve ration.

So, on the face of it, rates will remain high, inflation could be checked a bit, but the rupee will continue to harden. Says Yes Bank chief economist Shubhada Rao: "If it (the shift) happens over the medium-to-long term, the fundamentals get time to adjust. We have seen a very sharp appreciation of the rupee over the past month due to higher capital inflows. In a growing economy like ours, we need exports to grow, but the hardening rupee can affect that."

Sectoral impact. The hardening rupee will hit some export heavy industries such as IT, pharmaceutical and textiles. But oil and gas as well as capital goods imports are expected to get a fillip. In general, experts say that large exporters with healthy margins will be able to absorb the low rupee realisation, but smaller companies with thinner margins will find it tougher.

• Infotech: A rupee appreciation of one per cent will hit the profit margin of large IT firms by around 50 basis points, says Rajeev Anand, chief investment officer, Standard Chartered Asset Management.

The impact will be more marked for companies with thinner margins, typically, the smaller ones. The effect of the strengthening rupee was visible on the stockmarket. The BSE IT Index went down from 5,575.07 on 19 February to 4,672.56 on 2 April.

It rebounded after smart quarterly results from Infosys and TCS, but prices are still below their all-time highs. The margins of these companies could be further squeezed if the rupee continues to harden. Meanwhile, companies with high-end products with inelastic demand may remain unhurt by passing on the hit to the buyer.  

• Oil and gas: This sector saw buying as almost 70 per cent of the raw material, crude oil, is imported. Reacting to this, the BSE Oil & Gas Index has gained 13 per cent over the past month, while Reliance Industries has gained over 14 per cent.
• Textiles: Exporters of commoditised goods, such as textiles, might have to choose between margins and volumes. They are already facing competition from countries like Pakistan, Bangladesh and China. According to industry sources, in the year ending January 2007, Indian textile exports to the US grew by five per cent compared to Bangladesh's 20 per cent. And Pakistan's weakening rupee is making the situation worse.
• Sugar and cement: A stronger rupee will make it more attractive to import cement, and keep up the pressure on cement companies, already struggling after the Budget. And the possibility of exporting sugar will be bleaker now.

Outlook. In the short term, the hardening of the rupee would help fight inflation. But how far can the RBI and the government allow the rupee to appreciate? Abheek Barua, chief economist, ABN Amro Bank, says: "The rupee may climb to the level of 41 in the short term, but not beyond that because the RBI and the finance ministry will not like it to go beyond this level."

To check rupee appreciation, the RBI can take both monetary and non-monetary steps. RBI's recent monetary policy has abstained from monetary measures like hike in the CRR rate. Instead, non-monetary initiatives have been taken.

The overseas investment limit of Indian companies has been hiked, portfolio investment limit of listed Indian companies in listed overseas companies increased, ceiling on overseas investment by mutual funds enhanced, ceiling on prepayment of external commercial borrowings without prior RBI approval raised, and limit on permitted current or capital account transaction for individuals increased from $50,000 to $1,00,000 per financial year. The hope is that these steps will pull the rupee back to 43.00-43.50 to the dollar soon.

India's trade gap rose to seven per cent of the GDP in 2006-07 against the government's long-term target of 2.5-3 per cent, mainly because of the appreciating rupee. So the government will have to step in from time to time to check inflows in the capital account without keeping out the genuine investment needed to sustain growth.

As inflation subsides, the RBI, which is not able to buy dollars from the market now, can afford to buy dollars. Inflation showed some signs of abating in the last two weeks before it shot up again. Experts, however, say it will fall in the coming weeks as Rabi crops come into the market and the high base effect comes into play.

The strategy. Stay away from sectors that derive a bulk of their revenues from exports. Instead, go for industries such as power, telecom and media, which earn most of their revenues in the domestic market and are largely indifferent to exchange rate movements. While stocks of export-driven companies were struggling, Bharti Airtel gained around 12 per cent and Reliance Communication rose over 15 per cent in past one month.