Stronger rupee: End of India's export boom?

The high profitability of India's corporate sector should buffer the costs of rupee appreciation.

Since March, the rupee has risen sharply, by roughly 9 per cent against the US dollar, to a nine-year high. The rise has also been significant in what economists call "real effective" terms, meaning appreciation that is adjusted based on inflation, and measured against the currencies of a range of India's trading partners. This trend has brought a chorus of concerns that the strong rupee is eroding India's competitiveness, and that it represents a threat to the country's buoyant export growth. These concerns are overstated.

All else being equal, exchange rate appreciation will, of course, make India's exports more expensive, and hence less competitive. But all else is not always equal. For starters, the rupee's appreciation has lagged behind the regional trend. For example, between July 2005""when the Chinese renminbi was revalued""and December 2006, most regional currencies appreciated by about 10 to 20 per cent in real effective terms. At the same time, the rupee actually depreciated by about 4 per cent.

Moreover, the exchange rate is only one of many factors that determine an economy's ability to compete. Since India is becoming more competitive along other fronts""for example by boosting productivity and improving business conditions""export growth can remain buoyant despite a stronger rupee. Finally, and equally important there are benefits to a strong rupee. Corporations benefit from cheaper imported inputs, and households benefit from increased buying power.

In any case, a weaker rupee would provide no guarantee that exports would grow faster. India's experience during the 1970s and 1980 makes this clear. Even though the rupee lost more than half its value in real terms against the U.S. dollar, exports grew slowly, and India's share in world trade fell by a third. 
 

EXPORT COMPETITIVENESS
(All figures in %)	Currency  appreciation	Annual  export growth
South Korea  (2003-06)	23	20
India (2005)	4	30
	Average industrial  productivity growth (1972-2004)
South Korea	6
US	2
Japan	2.5

A survey of Asia illustrates how strong export performance can go hand-in-hand with a strengthening currency. In Korea, for instance, export growth averaged 20 per cent per year between 2003 and 2006""even as the won appreciated about 23 per cent in real effective terms. Exports in Indonesia and Thailand have also grown rapidly despite stronger currencies. Even India's 30 per cent export growth""the fastest export growth in 33 years""was achieved in 2005, when the rupee appreciated by over 4 per cent.

Rapid productivity growth plays an especially important role in explaining why a country's export performance can remain robust even when its currency strengthens. Again, the experience of the fastest-growing Asian economies is instructive. In Korea, industrial productivity growth averaged over 6 per cent between 1972 and 2004. This was significantly higher than in the United States and Japan, where industrial productivity grew by a mere 2 per cent and 2½ per cent, respectively, during the same period.

In India, strong productivity growth, robust corporate profits, and corporate pricing power augur well for continued competitiveness in the medium term. Over the last 15 years, total factor productivity growth""the productivity of capital and labour taken together""has averaged about 2 per cent per year, more than double that in the U.S. for the same period. With total factor productivity growth expected to rise to 2¼ per cent in the coming years, India should continue to gain competitiveness. In addition, service exporters may have some scope to raise prices, especially in industries that focus on customer-specific services. Finally, the high profitability of India's corporate sector should buffer the costs of rupee appreciation.

Where does this leave monetary policy? The Reserve Bank of India remains under pressure to resist the strengthening of the rupee by buying foreign currency. But the liquidity that such intervention would create could stoke inflation. And to mop up the impact of this liquidity, the Reserve Bank of India would have to issue bonds, possibly at higher interest rates. This could encourage further capital inflows and further appreciation pressure. Moreover, given the productivity-driven momentum of the rupee's appreciation, intervention is unlikely to be successful in the long run, since financial markets expect the rupee to appreciate eventually.

The best policy response would be to push ahead with reforms to boost competitiveness. The list is well-known. It includes investing to address the very serious problems in infrastructure, which cost an estimated 1 per cent per year in foregone growth. It also includes reducing import duties on capital goods to stimulate investment. Other possible measures include making labour markets more flexible to encourage job growth and a more efficient allocation of workers, and scrapping small-scale reservations to promote competition and innovation. Reforms in education are also vital to address the critical shortage of skilled labour. Finally, continuing to rein in fiscal deficits will make room to fund infrastructure investment. Implementing these measures on an aggressive footing will give India the best chance of realising its full export potential, and it will make currency appreciation less worrisome.

Kalpana Kochhar is the International Monetary Fund's mission chief for India, and Andrea Richter Hume is a senior economist on the Fund's India team