Ajay Shah: Three questions in world economics

India's increasing globalisation has meant more and more that currency policy has come at the price of autonomy in monetary policy.

I. How much do currency fluctuations affect exports? Over 2002-2007, the US CPI rose by roughly 14% while the Indian CPI rose by 28%: Indian producers lost ground by roughly 14%. At the same time, the rupee went up from Rs 49 to Rs 40, an appreciation of 18%. Putting the two together, we apparently lost 32% over this five-year period.

What happened to exports? Total receipts on the current account, which roughly corresponds to exports of goods and services put together, tripled. Merchandise exports doubled. Was this done by ceding profitability? No, profits of the corporate sector, as a whole, rose marvellously over these years.

This evidence contradicts the simplistic claims that INR appreciation will fundamentally damage exports.

What was going on? How was it that Indian exporters lost 32% owing to exchange rate and inflation considerations, but exports growth has been marvellous with improved profitability?

Many things were going on, and inflation plus exchange rates are only one element of the story. Customs duties were cut, so raw material prices in India dropped, thus improving competitiveness of production. Capital controls come down, enabling both inbound FDI and outbound FDI. The bulk of global trade now takes place within MNCs with globally dispersed production chains, so this FDI is the foundation of exports.

Transport and communications infrastructure improved. This induced reduced charges immediately, coupled with far-reaching gains by enabling new locations for production. When international telecom links became cheap, many non-tradeable services became tradeable.

The most important change that has been taking place is that Indian firms are learning to play the game of globalisation. Every day, individuals and firms are getting smarter with improved knowledge of science and management. This shift from an inward-looking India to an outward-looking India is central to explaining exports growth.

In short, exports growth responds to many things: reduced customs duties, removal of capital controls, integration into production chains caused by inbound and outbound FDI and the GST, improvements in infrastructure, smarter firms, inflation, exchange rates, etc. The effect of all these factors has added up to give a tripling of receipts at a time when we lost ground by 32% owing to inflation and rupee appreciation. India is changing so drastically that this 32% loss of competitiveness was swamped by the other factors.

Shankar Acharya asserts that the rupee is now overvalued. The present state of economic science does not permit such confident statements. REER calculations are extremely imprecise and have little content in explaining key relationships""as the above example shows. Economists know as little about whether a currency is overvalued as they do about whether Nifty will go up tomorrow. The only exception to this rule is this: if upholding an exchange rate of Rs 45 requires persistent USD purchases by the RBI, then Rs 45 is not the correct price.

II. Suppose we disagree; suppose we still believe the currency matters. Can policy makers distort it, and should we? If, despite all this, policy makers want to distort the exchange rate, there are three possible paths:

1. Certain exports could be banned. 2. Certain types of capital inflow could be banned. 3. The RBI could manipulate the currency market.

All three paths have costs. Banning exports hurts some firms and workers. Banning capital inflow hurts the recipients, and all users of finance by reducing competition. Manipulation on the currency market induces fiscal costs and distorts monetary policy, and these costs have bloated in the last decade.

Distorting the exchange rate in order to help exporters always comes at a cost, and the three policy choices involve a different incidence of this cost. Standard public economics reasoning tells us that if a government does want to help exporters, it is better to set up a transparent on-budget subsidy for exporters, rather than placing a non-transparent burden upon a few people.

But this raises fundamental questions. Outward orientation fuels economic growth because it forces firms to face competition and pass the global market test. Exporting is not a source of GDP growth by itself: it is a means to achieving competitive firms, which are what generate GDP growth. If Indian firms are subsidised""whether by a 10% on-budget fiscal subsidy or by an INR/USD rate of Rs 45""we fail to obtain improvements in competition and the death of weak firms, which is the real goal of outward orientation. Exporting is only a means to an end in growth strategy; "fake exports" propped up by subsidies do not achieve this end.

III. What is to be done? Shankar Acharya recommends a return to the "time-tested" macro policy framework that has prevailed from 1992 onwards. The trouble is, this prescription has been tried. It was precisely by doing this that the RBI got into a lot of trouble.

India has changed unrecognisably between 1992 and 2007, so the recipe of 1992 no longer works. In 1992, GDP was $240 billion and gross flows across the boundary were $97 billion. Now, we have GDP and gross flows across the boundary of a trillion dollars a year! This qualitative change in India demands a commensurate qualitative change in the policy framework.

As an example, the RBI and friends are keen to restrict ECBs, which might (at best) reduce capital inflow by $10 billion. This is a tiny issue when the scale of the problem that we are dealing with is $1 trillion, when the RBI purchased $12 billion in February alone. Bringing back these capital controls would give us micro distortions in return for nothing on the macro.

In summary, the macro policy framework which worked in the 1990s came with an expiry date of 31-12-1999. This operating manual visibly failed in March 2004 and again in March 2007: India's increasing globalisation has increasingly meant that currency policy has come at the price of autonomy in monetary policy. There is nothing to gain by trying it one more time. Bringing back capital controls, to make the old manual work, is retrograde and infeasible. The manual should adjust to the new India, instead of trying to force India to fit the old manual. Fresh thinking in open economy macroeconomics and monetary economics is required: to understand the new relationships between the various moving parts as they are (and not as they used to be), leading up to a new manual for monetary policy.