Calls to weaken rupee are misguided
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Rather like Goldilocks, commentators on the Indian rupee don’t like the value of the currency too low or too high—they would like it just right. Thus, when the rupee is weak, there are complaints that it is too weak; with a strong rupee, there are complaints that it is too strong. It is understandable that industry shills should press for a weakening of the rupee. But it is not just those with a vested interest in promoting domestic industry who are crying foul— eminent economists have now joined the fray. In this newspaper, former chief economic adviser Deepak Nayyar and economist Ajit Ranade have batted for a weaker rupee in the past few weeks. Nayyar, in particular, is explicit that this is best achieved through lowering the policy interest rate, which, it is alleged, is too high.
Unfortunately, such arguments suffer from the fallacy of thinking that the tail wags the dog. It is not that the rupee is too strong relative to the US dollar, but rather that the US dollar is weak—relative to a wide range of currencies, not just the rupee.
The figure shows a broad trade-weighted US dollar index from July 2016 to the present, and this clearly reveals that after a period of steady appreciation culminating approximately at the time that Donald Trump was inaugurated US president, the dollar has been steadily depreciating.
The rupee’s initial weakening followed by strengthening is a mirror image of this. Indeed, the dollar shows broadly similar behaviour vis-a-vis a range of advanced and emerging economy currencies. The fundamental driver is perhaps the market’s sense that Trump’s economic programme—tax cuts and infrastructure spending—is floundering. It is noteworthy that even with monetary tightening, the dollar has been weakening.
The real story is thus of dollar weakness, not rupee strength, and this turns the analysis on its head. For there is little if anything that Indian monetary authorities can—or should—do in the face of a fluctuating dollar, beyond attempting to smooth excess volatility. As it happens, the Reserve Bank of India (RBI) does intervene in currency markets, exactly for this reason, not to alter the underlying market-determined path of the exchange rate.
There is a second key proposition that critics miss. In a world of open capital markets, and in which the central bank wishes to pursue an independent monetary policy—in the case of India and many others, that choice is inflation targeting—we must, perforce, accept that the nominal exchange rate will be largely market-determined. In other words, you cannot simultaneously pursue an independent monetary policy and control the exchange rate—a fundamental insight that we owe to the Nobel economist Robert Mundell and to which many critics seem strangely oblivious.
Unless critics would like India to abandon our inflation-targeting monetary policy regime and substitute it with a fundamentally different system, such as fixing the exchange rate to the US dollar or something else equally radical, they cannot simultaneously grumble about the interest rate and the exchange rate in an open economy.
It is perfectly possible to debate whether the global economy is in need of systemic monetary reform, but that is very different from suggesting that India, acting alone, should abandon inflation targeting in favour of a more exotic policy approach. And, if we accept inflation targeting, or indeed any conventional flexible exchange-rate monetary policy regime, we must accept that the value of the rupee will be basically market-determined, full stop.
The truth is this: Those at present batting for a lower policy rate and/or a weaker rupee are, it would appear, concerned primarily with the interests of domestic Indian industry, not Indian consumers— who stand to benefit from a stronger rupee to the extent that, for instance, they purchase foreign goods or travel abroad— or indeed the economy as a whole.
Let us not forget that an artificially weakened currency can make up, at least for a while, for a multitude of sins, such as low productivity in domestic industry, and that is another reason why industry pushes for it. Why become more competitive and more efficient when, hey presto, your friendly neighbourhood central banker can bid down the value of the currency and let you stand on stilts for a while? This is an old trick. For instance, Canada for years cushioned low domestic productivity with a depreciated currency.
The RBI’s monetary policy committee is correctly focused on achieving the inflation-target mandate, and ought not to get distracted by the red herring that a strong rupee is hurting the economy.
Vivek Dehejia is a Mint columnist and resident senior fellow at IDFC Institute, Mumbai. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia