The current appreciation of the rupee against the dollar may hit the domestic employment scenario, with exporters threatening to shift base to other countries.
According to Subir Gokarn, chief economist at Crisil, the government is taking a big risk in allowing the rupee to appreciate.
He said since Indian exports, including software, were labour intensive, the potential loss in terms of man-hour could be heavy if exporters moved abroad to maintain their competitiveness.
Moreover, the threat of cheaper imports could also force domestic manufacturers to become more competitive, said Ila Patnaik, economist at the National Council for Applied Economic Research.
She said a sustained rise in the rupee would expose the entire manufacturing sector to international competition in the domestic market, forcing them to make fast adjustments.
Over the past few weeks, the rupee has gained considerably against most major international currencies, partially because of the interest rate differential. The rupee has appreciated 1.8 per cent in the current quarter, following a 5.2 per cent gain in 2003.
However, the finance ministry's position was endorsed by BL Pandit of Delhi School of Economics. He said the appreciation was a temporary phenomenon. Pandit said the local currency had to be aligned with its purchasing power in the international market.
To ensure this, the Reserve Bank of India should refrain from trying to arrest the rise, he said, and added that it should take steps to handle the cost of the rising foreign exchange reserve.
This line of thinking was endorsed by Icra economist Soumya Ghosh. He said it was difficult to visualise a scenario where the negatives of the rising rupee could outweigh its positive impact on the economy. He said it was the volatility of the currency that actually impacted the economy adversely.
Gokarn acknowledged that since most of the world currencies had risen along with the rupee in the same period, the country would not lose its competitiveness, except in some extent to China.
He said instead of providing a temporary remedy, both RBI and the finance ministry needed to decide if the current rise was a long-term phenomenon.
Gokarn said if the trend persisted there was no other option but to move towards capital convertibility and a corresponding cut in Customs tariffs.
Only then would the local demand for the greenback get a leg up, he said.