Ajit Ranade: Hitting exports to curb inflation is a bad idea

While exports create employment, it is not certain that a stronger rupee helps control inflation.

On a day when India's annual trade policy is being announced, let's examine the newfangled strategy of "hurt exports to fight inflation" that seems to be gaining ground, and has found many supporters among columnists and edit writers. This strategy advocates strengthening the rupee so as to kill inflation, never mind if exports suffer in the process. The choking impact of a stronger rupee on inflation is itself debatable (more about that later). But the negative impact on exports is immediate. If any evidence is required, just look to our eastern neighbour. Bangladesh has beaten India not just on Caribbean cricket grounds, but also in textile exports this year. Their exports to the US increased by 6 per cent while ours declined by 12 per cent, despite a much larger production capacity. Chinese exports rose by an even higher 23 per cent. And guess what happened to the three respective currencies?

The Chinese yuan rose by 2.9 per cent and the Bangla taka actually depreciated against the dollar! The Indian rupee, of course, rose smartly by 10 per cent since it was supposed to slay the inflation monster. Textile exports from India are already hampered by higher transaction costs, higher interest rates, lack of economies of scale and weakness in fabric finishing link of the supply chain. Then there's a fiercely competitive post quota world out there, where suppliers work on very thin margins, as low as 5 per cent. A rupee swing of 10 per cent is sufficient to wipe off margins of most small players. For India, not being able to take advantage of a quota free world in clothing and textiles is almost criminal. It's true that this sector needs productivity and technology boosts (in addition to what's listed above), but handicapping it with a currency burden is misguided to say the least. And it remains so for a variety of exporting industries from footwear, electronics to agro-processing. Not to speak of software and BPO.

Exports have become an important structural (that is, not cyclical) determinant of India's economic growth. Merchandise exports are becoming more broad-based and have been rising at annual rates of 22, 15, 28, 22 and (provisional) 25 per cent in rupee terms over the past five years. As a share of GDP, exports now contribute more than the entire agriculture sector. We now lament our export pessimism and argue that we should have adopted the East Asian miracle strategy of export-led growth a long time ago. But much of the East Asian (including Chinese) growth rode on a fixed exchange rate policy. It would be incorrect to blame the 1997 East Asian crisis on fixed exchange rates alone, since the Chinese devaluation of 1994, the indiscriminate lending to real estate and stock markets, the huge build-up of current account deficits, crony capitalism and so on were equally important factors. But this is not the place to debate the East Asian crisis. Suffice it to say that if we can't have an obviously undervalued exchange rate like China, the least we can hope for is a "fair" and stable rate since this is what an emerging economy needs to ride growth on the back of a robust exporting sector.

More than a third of all goods exported out of India come from small and medium enterprises (SMEs). If you count suppliers to large "export houses" and also ancillaries to larger players such as auto-components, the share of SMEs may very well be 55 per cent. These firms provide direct employment to at least 15 million workers. In fact this aspect has already found utterance in the annual policy unveiled by the commerce ministry. A few years ago we rechristened Exim policy to Trade policy, signalling a broader policy approach to exports and imports. Since then we have moved on, and these days the emphasis is on job creation, not dollar creation. Thanks to our huge pile of foreign exchange reserves, the focus is now on promoting labour intensive manufactured exports. So the bottom line is that exports create employment, imports don't. Don't pursue policies that will derail exports. Is your currency policy aware of that?

Finally, let's look at the argument of controlling inflation through a stronger exchange rate. In theory this works because imports increase the supply of goods, and cheaper imported goods help control the cost of the typical consumption basket. This works fine in a country like the US, where everything from coffee to footwear and clothing is imported. But look closely at India's import basket. The three largest components are crude oil (33 per cent), gold and gems (14 per cent) and electrical and non-electrical machinery, that is, capital goods (17 per cent). The latter two have an insignificant impact on inflation. The first does, but only if there is complete passthrough to the retail petrol and diesel prices. But these are de facto administered prices. Besides petrol prices can be tweaked without reference to the exchange rate, simply by reducing duties, or asking oil companies to hold prices (and reimbursing them from the tax kitty). This fiscal response is independent of rupee/dollar relation. The short run fiscal response to inflation (if at all effective) is actually to cut spending and cut indirect taxes.

The rise of the rupee against the dollar, by 10 per cent in 12 months is without precedent, and seems to have been determined by volatile flows, not by macrofundamentals. In the absence of hedging instruments (like currency futures), and a widespread hedging culture, affecting a large number of small producers, it seems pernicious to let the rupee rise abruptly, all in the name of inflation control. At the moment, with our relatively closed capital account, it is possible to control interest rates and currency independently. The guiding principle for the latter must be low volatility and a level anchored around an effective real rate. It is only when the capital account becomes fully open (against which even the die-hard free traders like Jagdish Bhagwati and John Williamson have cautioned), and when India has liquid and deep currency hedging instruments, that we can let the rupee "find its own level". Until then, it is important to remember that in India exports create employment. Imports do not reduce inflation by any great amount.