A strong case for a weaker rupee

If the terms of trade shock persist, the rupee will have to be a key part of the needed macro adjustment

For commodity-importing emerging markets, 2022 is delivering a double whammy. A surge in commodity prices — energy in particular — is delivering a substantial negative terms-of-trade shock to some economies.  Simultaneously, increasingly-generalised inflation in advanced economies is resulting in a continuous reassessment of how quickly their central banks will have to move. The Fed has telegraphed seven hikes this year, with growing prospects of more. Consequently, US 10-year yields have surged 75 basis points (bps) in less than a month.

 

Directionally, the macro consequences of these shocks are well known.  A negative terms-of-trade shock will hurt growth (by impinging on household purchasing power, firm margins and fiscal space), pressure inflation and widen current account deficits (CAD). Meanwhile tighter global financial conditions run the risk of dampening capital inflows into emerging markets, such that the balance of payments (BoP) is impacted on both fronts. If the shock is transient, macro buffers in many countries should be able to withstand these pressures. But what if the shock persists, as seems increasingly likely? How should policy respond to a more persistent terms-of-trade shock?

 

Nobel Laureate James Meade postulated back in the 1960s that developing economies must simultaneously strive for both “internal balance” (growth close to potential and inflation close to target) and “external balance” (CAD close to sustainable levels) given the hard budget constraints of external financing they sometimes confront. Viewed through this lens, the terms-of-trade shock risks disrupting both internal and external balances, by pushing up inflation and widening the current account for commodity importers.

How should policy respond? Two objectives require two instruments that Johnson (1958) and Cordon (1960) termed “expenditure control” and “expenditure switching”. The former is the traditional use of fiscal and monetary policy to respond to output and inflation gaps. The latter is to change the relative attractiveness of the tradable versus non-tradable sector, typically through changes in the real exchange rate, to help equilibrate the external sector.

 

Often these are self-reinforcing. If output gaps are positive, inflation is above target, and CADs are at unsustainable levels (i.e. an economy is overheating) tightening fiscal and monetary policy will slow growth, temper inflation and, by reducing imports, automatically narrow the current account deficit. The need to use a real depreciation to equilibrate the external sector may not arise, because demand compression has already restored imbalances.

 

 

But emerging markets currently find themselves in a piquant situation, wherein their recoveries from Covid-19 remain incomplete and below their pre-pandemic paths. Yet, commodity price pressures will create imbalances by pushing up inflation and the CAD, often to uncomfortable levels.  In this environment, concerted demand compression through tighter fiscal and monetary policy, can bring down inflation and the CAD, but will only further dent growth, already hurt from the pandemic and negative terms of trade shock. 

 

This is where the value of “expenditure switching” through a real depreciation of the currency becomes crucial. A real depreciation can help boost export volumes (by making them more competitive), reduce imports (by making them more expensive and inducing a switch to domestic substitutes) and thereby helping narrow the current account deficit without squeezing growth. Au contraire, a real depreciation helps narrow the CAD but by being expansionary and boosting the tradable sector!

 

Importantly, policymakers don’t need to artificially engineer this adjustment; it’s likely to happen automatically. When economies are hit by a negative terms-of-trade shock and/or slowing capital flows, the underlying equilibrium real exchange rate weakens.  Policymakers, therefore, simply need to enable this adjustment, albeit in a calibrated and non-disruptive manner.

 

Take the case of India. There is a growing expectation that crude prices will average 100/barrel or more in 2022. If this fructifies, it would push India’s full-year CAD to 3 per cent of GDP and above. To be clear, there is no imminent risk to macroeconomic stability because the RBI has a war chest of forex reserves that it can easily deploy. So this is not 2013 redux. It’s one thing, however, if the shock is temporary and the RBI is expending reserves for a few months, which is perfectly understandable. But if the shock persists and the CAD continues to remain above sustainable levels, a constant drip-feed of forex reserve losses month after month sometimes creates its own dynamic on the capital account. Instead, why not let the rupee move to its new equilibrium and thereby deliver the needed external adjustment to rein in the CAD more durably?

 

One can anticipate several objections to letting the rupee weaken which we seek to address preemptively:

 

Concern #1: A weaker rupee does not boost exports or reduce imports in the Indian context: There is a sufficient body of work to dispute this presumption. The RBI has cited several studies in its January 2021 Bulletin  — Chinoy and Jain (2018), IMF (2015), Pandey (2013), Hsing (2010) and RBI (Annual Report, 2015) — that together show that movements in the real exchange rate: (i) matter both for exports and imports (i.e. exchange rate elasticities are economically and statistically significant on both sides), and (ii) the Marshall-Lerner condition is met such that a trade-weighted real depreciation will help narrow India’s external imbalances over time, even if J-curve effects are initially observed. The figure (from our 2018 paper) reveals, for instance, how closely correlated India’s underlying CAD (ex gold and oil) is with movements in the Real Effective Exchange Rates of the rupee (REER). The sustained deterioration of the underlying CAD in the years leading to the pandemic raises questions about whether the exchange rate is too strong vis-à-vis its fundamentals-dictated equilibrium.

 

Concern #2: Will a rupee depreciation help exports if global growth slows in 2022? Both global growth and the exchange rate matter for exports, but they are found to matter independently. A real depreciation will help exports, no matter what the status of global growth. Booming global growth has helped India’s exports in 2021. But precisely because global growth is facing large downside risks in 2022 — with growth rates expected to almost halve in 2022 vis-à-vis 2021 — and could dent India’s exports, a real depreciation of the currency becomes even more imperative to increase external competitiveness.

 

Concern #3: If other currencies are also depreciating what is the benefit of the rupee weakening? Exchange rates are relative. Occasionally, therefore, one needs to run to stay in the same place. If India’s competitors undergo a depreciation, and India does not, this will result in an effective appreciation of India’s trade-weighted exchange rate. This will hurt export prospects, make imports cheaper (at the cost of domestic substitutes) and take the exchange rate further away from its new equilibrium. The more others let their currencies weaken, the more India will have to follow suit. A beggar-thy-neighbour approach may not end up helping anyone. But, from an individual economy’s standpoint, when faced with competitor currencies weakening, the imperative to follow suit is greater. 

 

Concern #4: Depreciation will add to imported inflation and increase the pressure to raise rates. A weaker rupee constitutes an easing of monetary conditions, because it is expansionary. Therefore, even if the inflation induced by rupee depreciation entails some more monetary normalisation, it’s not clear whether monetary conditions will tighten, and to what extent, because the new equilibrium will entail a weaker currency and higher rates. Furthermore, think of the counter-factual. Absent the rupee adjustment, monetary and fiscal policy would both have had to tighten hard to squeeze the CAD, which could meaningfully hurt growth.

 

If the oil and commodity shock is transient, policy can look through it, draw down forex reserves and maintain the status quo. But if the shock lingers and keeps the CAD elevated — as seems increasingly likely — India should welcome calibrated real depreciation of the rupee as a shock absorber to deliver the necessary external adjustment, at the lowest cost to the economy. Will there be collateral effects? There always are. Sticky inflation argues for calibrated monetary normalization, and exchange rate depreciation will only reinforce those dynamics. But the bigger risk emanates from preventing the rupee adjustment. Because that will necessitate squeezing the current account to sustainable levels through concerted demand compression, something the economy cannot afford coming out of Covid.

 

The writer is Chief India Economist at JP Morgan. All views are personal