It was only a matter of time before the tug of war over the rupee’s dynamics and the best possible approach in dealing with it were bound to become topical once again, as they now have. However, what is surprising is that the arguments for and against rupee appreciation remain the same, despite the broader macro setting being dramatically different from what it was just a couple of years ago. Sadly, the debate is encouraging the learning of wrong — but politically easy and palatable — lessons from China’s approach.
The merits of keeping an undervalued exchange rate are well known. One could be supportive of such an approach on a time-bound basis provided there are supportive policy initiatives to improve the competitiveness of the export industries that face the maximum risk from a strengthening rupee. Currency undervaluation should not be used as a perpetual life-support system. Remember, maintaining extreme currency undervaluation for an extended period of time results in economic abscesses and imbalances. Add to that a conscious policy choice of attracting, or being increasingly dependent on foreign savings (i.e. foreign capital), and one has a potent cocktail that is bound to give birth to some financial mishap.
There are five key areas to focus on in the ongoing debate over the rupee. One, the correct magnitude of rupee’s appreciation, and how it is different from the pattern of currency movements of other economies. Much is being made about the sharp appreciation of the rupee against the dollar and against inflation-adjusted trade-weighted basket of currencies, or real effective exchange rate (REER). But that is an incomplete picture. Both the bilateral nominal rupee-dollar exchange rate and REER have appreciated but the rupee-dollar rate is still weaker than what it was at the beginning of 2008, the year when Lehman went belly up.
More importantly, the REER appreciation in India’s case is much less pronounced than it is in other relevant emerging economies, despite several of them being more export-dependent than India. Indeed, unless one uses imagination that would make the creators of Avatar to go on the defensive, the rupee is not overvalued despite the REER appreciation. The currency is essentially recovering its lost ground. Further, the current account dynamics is reflective of what is happening to international commodity prices, especially crude oil prices, and the fact that domestic demand rebounded sooner and stronger than external demand. Indeed, the current account deficit in itself does not indicate that the rupee is overvalued.
Two, the causes of the pressure on the rupee to appreciate, and to what extend these causes are due to to the government’s policy of attracting more foreign capital to fuel faster growth. For all practical purposes, the government is adopting pro-growth policies that are likely to increase capital inflows into the country, which, in turn, will increase the pressure on the rupee to appreciate. However, when that pressure begins to manifest itself, policymakers seem to develop cold feet. It is worth bearing in mind that the bulk of rupee appreciation has taken place without much intervention by the Reserve Bank of India (RBI), indicating that capital inflows were only marginally higher than the current account deficit.
Three, there are still several constraints influencing the available menu of options for dealing with the effect of rupee appreciation on the real economy. The most serious constraint that no one is talking about is the lack of policy initiatives that are required to increase the competitiveness of the low value-added goods exports that face the highest risk from rupee appreciation. The majority of these businesses tend to be small, and almost all of them will find financial tools to hedge their exposure to currencies which may not be cost-effective (because of their small size) or they may lack in-house expertise to deal in them.
Four, RBI’s approach has been spot on, within the policy constraints. Much has been written about RBI allowing too rapid an appreciation of the rupee, both against the dollar and in REER terms. Frankly, I don’t think RBI had much of a choice given that it was trying to shrink the excess liquidity in money markets. Heavy intervention would have warranted measures to sterilise its intervention in the foreign exchange market, which, in turn, would have meant either using market stabilisation scheme (MSS) and/or cash reserve ratio (CRR). Neither was a practical option as recovery was uneven and uncertain, and India still needed capital inflows for funding its current account deficit.
And finally, much has been written about China’s undervalued currency, but what is overlooked is the critical difference between India and China: the bulk of the pressure for China is created by its huge current account surplus, while in India’s case it is created by capital inflows, which, in turn, are driven by a combination of India’s growth dynamics that relies on foreign funding, global factors, and perceptions about the rupee being undervalued.
Importantly, India and China adopted different exchange rate policies to deal with the crisis (see chart). China abandoned its crawling appreciation approach, while India allowed the rupee to weaken in order to cushion the hit from the global crisis. Consequently, in the down leg of the crisis, China’s REER appreciated while that of India’s depreciated, and in the recovery phase, they reversed course.
Exchange rate is too important and too sensitive for the central bank of a developing economy to either lay all its cards on the table, or allow excessive currency volatility. India’s underlying growth drivers suggest that its growth will be much higher than that of most other economies. Partly owing to the government’s focus on infrastructure, revival in corporate capex, chronic current account deficits, and an ambitious divestment programme, India needs foreign capital inflows.
“Active” capital account management is always an option for Indian policymakers, but the underlying capital inflows are still not overwhelming. Further, net commercial borrowings have not really picked up significantly, and India will need foreign participation for a successful divestment programme. The first option — if policymakers are forced into action — should be to make NRI-related inflows less attractive.
Ultimately, it is counter-productive for the government to shoot for at least 9 per cent annual GDP growth on a sustained basis, as that will need foreign capital to fund that growth, but then move to selectively restrict capital inflows owing to its own inability to manage India’s economic success. A more sensible and long-lasting solution is to announce an effective fast-track initiative for enhancing the competitiveness of low value-added exports.
Positive productivity shocks will justify further appreciation of REER, whether the government likes it or not. The government is best advised to undertake policies that will allow that appreciation to be absorbed with least amount of dislocation. Or the forces of globalisation will do it in their own painful way.
The author is head of India and Asean economics at Macquarie Capital Securities, Singapore
Views expressed are personal
