The dramatic (37.5 per cent) growth in exports in 2010-11 confirms my long-standing belief that the exchange rate is not a major determinant of India’s export competitiveness. Despite the rupee strengthening by four per cent on an average in 2010-11 – 5.5 per cent, if we use the average rate three months in advance, when most exports were likely priced – exports surged like never before. Indeed, since 2003-04, there has been virtually zero correlation between the average value of the rupee (with or without a three month lead) and exports – and, for that matter, imports – in any particular year.
The most important factor for export growth is, obviously, the state of global markets. In 2009-10, when the global economy was reeling from the fallout of the global debt crisis, exports fell by 3.5 per cent despite the rupee being more than 10 per cent weaker than in the previous year. If people aren’t buying, a weaker currency has all the impact of pushing on a string.
More specific to, and much more significantly for, India, our exports growth has benefited from the more or less continuous rise in our productivity. Each year, India’s productivity jumps as a result of improvements in telecommunications, transportation, business skills, financial markets, government finances and even bureaucratic friction. To be sure, these improvements are uneven and piecemeal, but, from time to time, and differently for different industries and companies, the cumulative change results in a bolus of increased competitiveness.
Most exciting, of course, is the fact that we still have a long way to go before our productivity is even close to plateauing out, as it has in developed economies like Japan, Germany and the US. In other words, export growth is likely to remain largely independent of the exchange rate for some more years.
This suggests that making the rupee fully (or substantially more) convertible will have little impact on export competitiveness or export growth. And, given that the world is very loudly looking for a wider array of reasonably stable convertible currencies, it is definitely an excellent time to push the rupee forward. The benefits to the economy would be multifold, from dramatically increasing foreign investment to further adding to business productivity to making life much simpler for citizens.
Of course, greater convertibility would likely lead to higher rupee volatility. However, our reserves are more than adequate to prevent any dramatic macro consequences — we had to draw down only about $30 bn of our reserves (around 10 per cent) to combat the 2008-09 crisis, and we are back at around $300 bn and counting.
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To address the impact of this higher volatility on a micro-level, the Reserve Bank of India (RBI) should license selected NBFC’s as “super-AD2’s” who could provide substantially improved service in the FX arena to small and medium enterprises, which are very poorly served by the current banking establishment. RBI has indirectly acknowledged this need by launching currency futures to provide small FX users an alternative window; however, as is well-known by now, this hasn’t worked for hedgers. Indeed, full convertibility would also make the futures market more attractive for hedgers since physical settlement would automatically be permissible.
However, before RBI can throw the switch, we need – hold your breath – a meaningful debt market. You can’t have a convertible currency till there is sufficient liquidity in the debt market to where the FX forwards reflect interest rate differentials at different tenors. RBI has acknowledged privately that the ONLY way we can get there is if nationalised banks become much more aggressive in trading their interest-sensitive assets. RBI could push banks to do this — by, say, eliminating the held-to-maturity segment, which would require banks to mark their entire bond portfolios to market every day. But the risk is that most nationalised banks may well back completely away from risk and stop holding government securities, which could result in dramatic problems for the government’s borrowing programme.
However, since the finance minister announced in the last budget that the Office of Debt Management would be set up and operational shortly, RBI will soon be free to focus on monetary policy and market development. The transition will certainly have glitches — some having to do with RBI being unable to stop mother-henning; some, more seriously, with our politicians having to learn that the market will severely punish fiscal indiscipline. But you can’t make an omelette without breaking eggs.
The good news, though, is that the increasing activity of all sections of society, abetted by the media, has already started the process of demanding discipline from our political servants. The energy and continuity of these efforts confirm that there’s no turning back.
The new India is, indeed, in play! Aa jaon maidan mein!
As for the rupee — my guess is that we will see full convertibility in not much more than two years.