Trade deficit and exchange rate

WORLD MONEY

The size of the reserves seems to be keeping us from undue concerns about the deficit in merchandise trade. It has also been argued, and correctly so, that the rise in deficit is a sign of the pick up in industrial investment and manufacturing activity; the other reason, of course, is a sharp rise in oil import bill.

Incidentally, the international price had dropped below $ 50 a barrel, but has since inched up to approximately $ 55. The merchandise trade deficit was $ 28 billion up to December 2004 (RBI data based on payments) and $ 27 billion for the year 2004-05 (commerce ministry data based on customs clearance "" reported as $ 19 billion up to December 2004).

Ignoring the different bases for compiling the data, which give different figures based on the leads and lags on imports and exports, there is another major variation: customs cleared, that is the commerce ministry data does not include defence imports that are, however, captured in the RBI data.

Considering this factor, and the data available so far, one would be surprised if the RBI figure for merchandise trade deficit for fiscal 2004-05 would turn out to be less than $ 35 billion. It is a large number by any yardstick.

The indications so far are that the number for the current fiscal year could well be even larger, perhaps going beyond $ 50 billion. The commerce ministry data for April disclose a trade deficit of $ 3.9 billion, three times the corresponding figure for April 2004.

Recent months' data evidence that exports growth is slowing while the import number keep galloping "" in April, for example, exports grew 17 per cent, while imports grew 51 per cent. Factoring in defence imports and if the April trend continues, we could be heading for an even higher number than $ 50 billion.

On the export front, the fall in textile exports reported recently defies explanation. For one thing, export quotas were abolished from the beginning of this year and this was supposed to benefit principally China and India. It has led to a sharp jump in Chinese exports to both the European Union and the US, with the result that import protection measures are being seriously considered.

China, which had imposed export duties on many varieties of textiles, in order to curb the growth, has now decided to withdraw the duties in retaliation for the trade protectionist measures. By logic, all these developments should have benefited our textile exports but, strangely, at least so far they have not.

As a response to European and American pressures on China to curb textile exports, it seems that Chinese exporters are looking at establishing exporting units in India. If this happens, surely we could learn a lot from seeing first-hand how the Chinese have built their phenomenally successful export industry.

Our worthy textile minister, however, is against the idea of the Chinese investing in our textile export industry. One would have thought that, if the target of $ 50 billion of textile exports by 2010 is to be met, we need all the investment that we can get "" domestic or foreign.

The actual investment in 2004-05, at Rs 15,000 crore ($ 3.5 billion) was far below the investment needed to take full advantage of the quota-free regime and meet the target level. Apart from earning foreign exchange, the potential of export growth to create employment should not be lost sight of.

There is, of course, another impediment to export growth at a time when we are facing a merchandise trade deficit in excess of $ 50 billion: the exchange rate. In terms of the REER Index model, which the RBI seems to be using, the rupee is already overvalued by approximately 6 per cent.

In any case, the model has become completely out-dated for measuring the competitiveness of the exchange rate. The weights are based on trade data of 1993-94. Since then two major changes have taken place:

China, which does not find a place in the five-country basket, is now our second largest trading partner. Inasmuch as the yuan is pegged to the dollar, the effective weight of the US currency would increase when China is included, as it obviously should be.

Again, services exports have become far more important now compared to 1993-94 and we need an index model which also includes services. Given that perhaps 75 per cent of services exports are to the US, this would further add to the dollar's weight in the basket.

In short, the current model to my mind, significantly underestimates the actual erosion in the competitiveness in the exchange rate.

Empirical analysis suggests another important influence on our export growth "" strength in world demand. This factor also does not seem to augur very well "" the IMF has cut down its estimates of the growth in world economy, and another pointer is that commodity prices other than oil, particularly metals, have softened evidencing a general slowing of demand.

On the capital account, foreign institutional investor flows have been negative in the first two months. Reserves as measured in dollar have fallen by $ 3 billion during April, but this could well be because of the rise of the dollar internationally.

Tailpiece: The governor of the Thai central bank at the time of the balance of payment crisis has recently been ordered to personally pay $ 4.6 billion spent in defending the baht in the 1997 crisis. Reddy, beware!

Email: avrco@vsnl.com