The popular view in India is that a strong currency means a strong economy: rupee appreciation is a sign the economy is strengthening, and vice versa. As the rupee has been gaining strength in recent weeks it is seen as a welcome development, a sign of success of the new government and of the coming of 'good times'.
However, introductory textbooks in economics explain just the opposite: how a strengthening of the currency reduces the competitiveness of traded goods and a weakening of the currency increases it. The concept of the Real Exchange Rate (RER) and its movement is related and equally important. To illustrate: If India has an inflation rate of 10 per cent in a particular year and its trading partners have an inflation rate of two per cent then there is an inflation rate difference of eight per cent. If the exchange rate and productivity levels remain the same then, due to this difference in inflation rates, there would be an eight per cent appreciation of the Indian rupee in terms of the RER. An eight per cent appreciation in the currency has, in substance, the same effect as a lowering of import duty by eight per cent.
The successful economies of East Asia, Japan, South Korea and China, consistently pursued the policy of having an artificially low exchange rate so as to achieve success in manufacturing and exports. Their central banks intervened in the currency markets and accumulated reserves. As a result China now has reserves of over $3 trillion. This strategy was critical for the remarkable speed with which they industrialised and began to bridge the gap with the West, driven by a very rapid growth of exports of manufactured goods. When success in exports and trade surpluses became too large, there was pressure from the international community for appreciation in the exchange rate. China has been facing this pressure in recent years.
For countries experiencing a balance of payment crisis, a sharp depreciation of the currency has been a standard part of the IMF and World Bank packages. Such depreciations have worked in varying degrees over the short run in reducing imports, enhancing exports and increasing domestic production. A solution for the peripheral weak economies of the euro zone, such as Greece, is that they leave the euro zone, have their own currency, depreciate it and increase competitiveness.
More recently, in the wake of the global financial crisis in 2008, US monetary policy has been exceptionally loose in the hope that abundant availability of money at almost zero interest rates would lead to economic recovery. One consequence of this has been a surge in capital inflows to emerging markets in the quest of better returns. This, in turn, led to the appreciation of the currencies in these emerging markets. Brazil was the most vocal on the adverse effects of this artificial, capital inflow-induced appreciation of their currency on industrial growth as imports become cheaper and manufactured exports more expensive. India has been a notable exception in not reacting to the artificial appreciation of its real exchange rate and the consequent aggravation of the downturn of the economy, especially in manufacturing.
The interesting question, therefore, is: Why was the Indian response so different? The answer lies in trying to understand who the winners and losers are with the appreciation or depreciation of the currency. A competitive exchange rate clearly benefits manufacturing and value addition in India, creating jobs and employment. If value addition in the domestic supply chain is over 30 per cent, the benefits are easily seen. The recent improvement in the performance of textile exports after the depreciation of the rupee is an obvious example. On the other hand, there are those who gain by the currency becoming stronger. Those with higher incomes who spend holidays overseas or fund their children's education abroad find these more affordable.
The biggest beneficiaries are consumers as a class. Our malls and retail outlets are all increasingly full of imported goods ranging from fruits to chocolates and cheeses, to household appliances and furniture, to even statues of our gods and goddesses. All these replace domestic production, especially from SMEs, with the consequent loss of manufacturing jobs. Traders as a class gain over producers.
The government had earlier chosen to subsidise consumption of diesel and petrol and it needed a stronger currency, especially when oil prices were rising, to contain the fiscal deficit. Fortunately, with diesel and oil subsidies being phased out, the government's need for a stronger currency to contain the fiscal deficit is no longer there.
Large corporate groups that have raised funds overseas through external commercial borrowings for activities in the domestic market are another significant group which gains from stronger exchange rates. Exchange rate appreciation helps in lowering the real costs of debt repayment. But large companies collectively would gain more with the success of Indian manufacturing and higher GDP growth, as the consequent growth in domestic demand for their goods and services would benefit them more. If India is to succeed in manufacturing, in creating jobs for its young, and in enabling entrepreneurs to succeed and grow in manufacturing, then it would need to recognise the necessity of having a competitive exchange rate. More than interest rates and import duties, the exchange rate plays a vital role in enabling success in manufacturing.
There is considerable merit in the view that our downturn, especially in manufacturing, would have been moderated if the RBI had intervened in the market to gradually bring the exchange rate below Rs 60 where it needed to be and in the process built up reserves to around $400-500 billion. For the economic recovery, which seems to have begun now, to be robust and for sustained success in manufacturing, the RBI needs to aggressively intervene in the market and buy dollars to undo the appreciation that capital inflows are causing. This would be easier for the RBI if there is better appreciation and a broader national consensus on the necessity of a competitive exchange rate.
The writer is member-secretary of the National Manufacturing Competitiveness Council
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