The dangers of rupee appreciation II

World Money

An overvalued exchange rate is a dangerous macroeconomic variable

Last week ("The dangers of rupee appreciation", October 13) I had argued that on the basis of both the level of the real effective exchange rate (REER) index, as also the deficits on merchandise trade that we are sustaining year after year (say 2.5 per cent of GDP), the rupee seems overvalued rather than undervalued.

This is all the more so, given that further duty cuts are on the cards. And these deficits are occurring even in the absence of an investment boom. If, despite the trade deficit, we registered surpluses on the current account for the past couple of years, it is principally because of inward remittances from non-resident Indians and services exports.

As for the first, the exchange rate may not be all that relevant to the flow, at least to the extent that money comes in to support families in India.

Again, as for the second, we still enjoy significant comparative advantage but should not ignore either the pricing pressures or the political backlash building up in the US against the export of jobs. In any case, despite a strong surplus in invisibles, the current account is in the red in Q1 of 2003-04.

The surplus on invisibles should not blind us to the overwhelming importance of the merchandise sector to the economy. On this issue, many still seem to believe that the exchange rate is relevant only to the merchandise export sector, which is say 10 per cent of GDP.

One does not quite accept the logic which is more a hangover from the days of import controls and high customs duty. With free trade and lower import duties, the exchange rate is equally important to domestic industry selling in the local market, in terms of competition from imports.

For instance, most basic goods produced and sold locally are priced at the import parity levels. The margins in such industries will obviously get squeezed with a rise of the rupee.

In many ways, perhaps the most dangerous macroeconomic variable for a developing economy is an overvalued exchange rate in real effective terms "" it was at the root of the crises in Mexico (1994 -95), south east Asia (1997-98) and Argentina (2002), to quote only the most recent cases.

They all depended on capital flows to sustain overvalued exchange rates "" for a while. Nor should we forget the disastrous impact of the restoration of the pound to its prewar gold parity in 1925. The resulting deflation destroyed jobs; inflation, within limits, is an incentive to investment, to create jobs, to consumption and to investment.

"The case for currency appreciation" is not as benign as advocates make it sound. Lest we forget, the greater the misalignment, more messy and costly will be the cure.

Macroeconomic variables are not thermostats, quickly reverting temperatures to the desired level. More often, market participants are trend followers, not many of them are contrarians. When the rupee is rising, participants' actions themselves will keep pushing it way beyond the equilibrium band, until the inevitable and costly correction. (For example, how many years of ever-growing deficits on the current account in the US were needed before market participants paid any attention to it?)

In our patriotic enthusiasm for a stronger rupee, we should not overlook such cases; nor that those who do not learn from history are condemned to repeat it! This apart, in our case, an overvalued exchange rate has the potential to lead to the death of economic reforms and the globalisation process, should a couple of large companies close down because of their inability to meet with competition from imports. Nothing would please the Swadeshi Jagran Manch more!

Such dire prospects apart, rupee appreciation will also kill the animal spirits of entrepreneurs in sunrise export industries like vehicles and auto ancillaries, in which India has enormous potential, which is just beginning to be exploited. The Chinese are not fools to resist appreciation despite a far stronger merchandise trade account. An attitude of "let the markets take their own course" would be dangerous!

Currency volatility

Swaminathan Aiyar recently argued that reduced intervention of the Reserve Bank of India "may mean a sharp rise of the rupee followed by volatile ups and downs". He believes this will "reduce moral hazard and complacency".

It is difficult to appreciate the virtues of volatile exchange rates "" except for a currency trader (how many jobs does he create?). Surely, volatility adds to the risks of international trade and investments and is an impediment to globalisation?

How can the principle of comparative advantage, already crippled by subsidies, work when this advantage keeps changing every minute with the exchange rate? Supporters of globalisation perhaps need to review their faith in the virtues of volatile exchange rates.

While discussing the dollar's exchange rate, The Economist recently said that "markets have now switched their attention from growth rates to America's huge current account deficit" "" so the fate of manufacturing jobs increasingly dependent on exchange rates in a globalised economy, is to be decided by which variable a few hundred currency dealers find fashionable at a given point of time! The cost of reserves? See the next article.

Email: avrco@vsnl.com