In a series of columns since April this year (Business Standard, April 10, April 24, September 23 and October 28), I have been expressing mounting concern over the unprecedented appreciation of the rupee in real terms since March 2009 (around 25 per cent according to a six-currency index and 15 per cent by the 36-currency index up to September 2010) and its negative effects on our balance of payments and the competitiveness of our tradable industrial and service sectors. In September, based on available data, I foresaw a record current account deficit (CAD) of 4 per cent of GDP or higher for this year, 2010-11. At that time, senior official spokespersons were still predicting a CAD of around 3 per cent of GDP. Last week, Goldman Sachs, in its widely reported “Asia Economic Flash” report (November 16), has predicted a CAD of 4 per cent of GDP for 2010-11 and an even higher 4.3 per cent for 2011-12. It has flagged the “deterioration in external balances as the biggest risk to India’s growth story, and one that investors should follow closely”. Now that Goldman Sachs has spoken, I am reasonably hopeful that our policy-makers might take a little more notice of the growing problems than from my scribblings.
But my concerns were not limited to the widening external deficits caused, in part, by the sharp rupee appreciation of the last 18 months. They also extended to the damage to the momentum of growth in our industrial and service sectors, stemming from cheaper import competition and less profitable exports because of an increasingly over-valued rupee. Traditionally, the waxing and waning of industrial growth in India is attributed to changes in monetary policy, global economic conditions and business cycles. These are all undoubtedly relevant factors, as are more long-run impediments to sustained industrial buoyancy, such as poor infrastructure, inflexible labour laws and distorted indirect tax policies. I believe that in the last three years, gyrations in the real effective exchange rate (REER) of the rupee have also played a significant role.
Figure 1 presents the profile of annual industrial growth, by quarter, since 2005-06. Growth in two measures of industrial activity is shown: the index of industrial production (IIP) and real industrial value added from the national accounts data. It is reassuring that the two have almost identical profiles. Actually, this is not that surprising, since the IIP data are an important input into the national income estimates.
What is noteworthy is the enormous variation in the rate of industrial growth experienced over the past five years, ranging from an initial peak of 14.5 per cent (as per the value-added series) in 2006-07 Q4 to a trough of 0.8 per cent in 2008-09 Q4 and back up to 15.1 per cent in 2009-10 Q4, before plunging down again.
Figure 2 shows the profile of the six-currency REER index over the same period. (The 36-currency index has a very similar profile but follows a lower level throughout).
A plausible story of industrial growth over this period could run as follows. The industrial upswing, which had begun in 2004, gathered steam during 2005-06 and 2006-07, driven mainly by an exceptional boom in private corporate investment (and savings), a buoyant global economy and a supportive exchange rate policy, which entailed active RBI intervention and partial sterilisation of rising capital inflows. Despite steady tightening of monetary policy, liquidity remained ample. A sharp increase in the REER in 2007-08 Q1, on the back of surging capital inflows and some ministerial strong-arming, dented the momentum of industrial growth, which was also affected by the cumulative tightening of monetary policy to combat commodity-price-driven inflation. Thus, the pace of industrial growth had dropped below 6 per cent, well before the marker event of the global financial crisis, the Lehman collapse of September 2008, brought the full downdraft of the global crisis to India.
As the Great Recession took hold and capital inflows to India reversed, industrial growth fell sharply through 2008-09 to a near stagnation levels by the final quarter, while nominal and real exchange rates also plummeted. Massive spending increases by government and very expansionary monetary policy by RBI contained the damage to overall economic growth and helped initiate a strong industrial recovery throughout 2009-10, which was aided by the wider recovery of global output and trade. Capital inflows resumed and, unlike in the past, RBI followed a largely non-interventionist policy after spring 2009. As a result, the six-currency REER rose steeply throughout 2009-10 to a new record level of nearly 120 by the first quarter of 2010-11. With the index having crossed 110 by the last quarter of 2009-10, the predictable slowing of industrial dynamism set in during the first half of 2010-11; the rate of increase in the IIP dropped from 16 per cent in 2010 Q4 to below 9 per cent in the second quarter of 2010-11. For the latest available month of September, the annual rate of increase in the IIP was as low as 4.4 per cent.
So, that’s the summary tale I would like to tell, which accords a significant role to the real exchange rate in explaining two bouts of industrial slowdown in the last five years. It’s by no means the only explanatory factor. But I do think it’s a significant one. And that’s one more reason why the current over-valued level of the rupee needs fixing, downwards. To put it more strongly, I doubt that we can regain and maintain double-digit industrial growth without such a downward adjustment. And if continuation of non-interventionist policies leads to an even stronger rupee (after a possible hiatus in capital inflows because of the current Irish crisis), then my doubts turn to certainty.
The slowdown in industrial growth also augurs badly for employment. There are good reasons to believe that the recent bouts of industrial downturn have exacted a disproportionate toll of small/informal/unorganised industrial segments, which tend to be more labour-using than large/formal/organised sector industry. There is a woeful absence of reliable time series data on employment to validate (or reject) this presumption. However, the findings of the new Labour Bureau survey of employment, published last fortnight, are certainly consistent with my worries. The unexpectedly high open unemployment rate of 9.4 per cent and very high ratios of casual employment and self-employment in 2009-10 certainly point to enormous labour market stresses. Many factors are at work but one of them is an increasingly over-valued rupee. Surely, for this reason alone, the government and RBI should reverse the current strong rupee policy and reap the gains of higher output and employment; in short, opt for more “inclusive growth”. Perhaps we have to wait for Goldman Sachs to say all this!
The author is honorary professor at ICRIER and former chief economic adviser to the Government of India. The views expressed are personal
