Rupee at 64 against $: The cause and effect of currency appreciation

Are we in the midst of a classic feedback loop of portfolio flows leading to rising share prices

The recent appreciation of the rupee in nominal, and even more so in real, terms against the currencies of our major trading partners, is expected to continue. A recent poll by The Economic Times (April 11) suggests that it may surge to Rs 63 per dollar in a month’s time. Our esteemed minister for commerce and industry (and apparently some other members of the government) seems to believe that the underlying reason is “second generation reforms” like the goods and services tax etc undertaken by the National Democratic Alliance (NDA) government, and that the “exchange rate alone cannot be the sole way of incentivising exports”; that the focus should be on improving logistics and infrastructure (Mint, April 17).  Shahid Bhagat Singh Marg should be happy with the minister’s endorsement of its policy.

The other side is that sectors like pharma, jewellery, textiles etc are suffering. So is the information technology industry, already hit by the tougher visa restrictions in the US. So are industries competing with imports (tyres, for example), and the tradeables sector in general. Surely one reason for the steel sector’s non-performing assets is the uncompetitive exchange rate? The basic theory of trade demands purchasing power parity in exchange rates: In terms of the Reserve Bank of India’s real effective exchange rate index (six country basket) the rupee was overvalued by 30 per cent in March (base 2004-05). Surely that is relevant to the health and growth of our tradeables sector — not just logistics and infrastructure? In mathematics there is a beautiful concept generally referred to as “necessary and sufficient conditions” for the validity of a proposition. For trade to balance, infrastructure could well be a “necessary” condition — but not “necessary and sufficient”.

Another point often overlooked is that the exchange rate is even more important for non-differentiated, commodity kind of goods bought and sold on competitive prices: Most of our exports are of this nature. On the other hand, for differentiated “products”, sold on technology and brand (Lexus cars or Sony TVs, for example), price (and hence the exchange rate) is a less important factor. (In fact, for luxury goods, higher price is a factor that attracts buyers.)

Our dependence on exports of mostly non-differentiated goods and an overvalued exchange rate has meant that, as China gets out of manufacturing non-differentiated goods (garments, for example), it is being replaced as a supplier not so much by India but by “Bangladesh and Vietnam in the case of apparels; Vietnam and Indonesia in the case of leather and footwear; ...the opportunity is narrowing” according to the pre-budget Economic Survey. This apart, many “made in India” differentiated products are dependent on imported components. One recent example is mobile phones.

Though President Trump’s solutions to correct the US’ trade deficit may be wrong (see last week’s article), he has correctly identified it as a cause for unemployment in his country. In our case, job creation is even more important: Two thirds of our population is below 35 years; and 12 million are entering the job market every year even as we need to reduce the number of people dependent on agriculture for livelihood. Clearly, employment creation needs to be our first macroeconomic priority. And an overvalued rupee is not the way to create jobs but of destroying them. A rapid increase in export-based manufacturing is perhaps the only way to do so as many countries in Asia, from Japan to Vietnam, have shown.

Are the external deficits inevitable since our savings are lower than investments? But surely national savings are not a “given”? They are also indirectly influenced by the exchange rate in all three sectors — government, corporate and personal. The first and second because of lower profitability and output, particularly in the tradeables sector, and the third because it encourages more expenditure on consumption of imported goods and foreign travel and hence lower savings. 

The result of our exchange rate policy is that, despite the sharp fall in the price of oil, our single largest import, and  huge secondary income in the form of remittances, the current account remains in deficit, and the international investment position is a negative $360 billion plus. The rupee appreciation is not “muscle”, showing the strength of our external sector, but a “swelling” resulting from fickle portfolio capital inflows (see The Other Side, March 30). Are we in the midst of a classic feedback loop of portfolio flows leading to share prices rising, rupee appreciating and attracting further portfolio inflows in the bond and equity markets?

 

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com