In the last three months, the Indian rupee appreciated by 4.5% versus the US dollar. This quarterly rise is its best showing against the greenback in the past 42 years. It’s no coincidence that dollar inflows during March hit a 15-year record of nearly $8.9 billion. These inflows were both into debt and equity, and surely put upward pressure on the rupee. The capital inflows have been strongly positive for the past couple of months, after significant outflows in the previous five months, which had included the dreaded demonetisation period.
Markets are euphoric for several reasons. The sweeping mandate won by the Bharatiya Janata Party (BJP) in the Uttar Pradesh elections is one. The passage of the goods and services tax Bills in Parliament is another. The gross domestic product data for the third quarter of this fiscal year, that showed relatively minor negative impact of demonetisation, is a third reason for upbeat markets. A muted current account deficit which may be close to a surplus now, an uptick in the index of industrial production, and adequate foreign exchange stock, are collectively a fourth reason for investor enthusiasm. Finally, moderate inflation and steadily rising exports are cause for optimism as well. Hence the inrush of capital flows.
But remember, capital inflows are notoriously fickle, and can make a sudden U-turn as well. Hence, we keep the insurance buffer of exchange reserves. The big positive trigger could very well be talk of a sovereign rating upgrade for India, after which all bets are off. Then, by comparison, the present exuberance will look like a lukewarm reception.
But let’s examine whether this somewhat unexpected and rapid rise of the rupee is warranted. The first consideration is domestic inflation. India’s headline inflation is above 5%, and likely to stay there. This is the consumer price index based one, not the traditional wholesale price index based one. This means that the domestic purchasing power of the rupee is depleting at the rate of about 5%. If that is so, then there must be external parity too. It can’t be that domestically the rupee is losing 5%, but externally it is gaining 5%. This is inconsistent.
Indeed, that’s why in the medium to long term, the rate of depreciation of the rupee against the dollar is the difference in the inflation rates in the two countries. Temporarily, this thumb rule can be breached by movements in the currency due to typically volatile capital flows. The volatility is kept in check by interventions by the central bank.
The second consideration is of the real effective exchange rate (Reer). The Reserve Bank of India publishes the Reer against a basket of trading currencies. This shows whether the rupee is overvalued or undervalued, with respect to a benchmark level. Sharp deviation from the benchmark means that a correction is due. The present Reer is at 116, which is 16% above the “neutral” level. More importantly, the Reer has drifted up by 6% in the past one year, indicating an excessive strengthening.
The third consideration is of export competitiveness. India’s exports turned into positive growth in the past five months after a long period of almost two years in negative territory. The ambitious trade policy announced in late 2014 aimed to take India’s exports to $900 billion by 2019. Current manufacturing exports are barely $300 billion.
While it’s true that export performance is influenced much more by global conditions and income growth in our trading partner countries, it is also true that an excessively strong rupee can hurt exports. In sectors like textiles, leather products, auto components, industrial goods, chemicals and pharmaceuticals, even a 3-4% downward movement in the rupee can make a difference between being profitable or making losses. Even though the import content of some of our exporting sectors may be high (such as in oil refining or diamond polishing), a weaker rupee is welcome. Exports create jobs, imports don’t. The rupee cannot afford to strengthen in comparison to East Asian peer currencies, including the Chinese renminbi.
It is said that since India is a net importing country, a stronger currency is beneficial. This argument is misleading on many counts. Firstly, India’s current account deficit has been financed consistently by capital inflows into stocks, debt and foreign direct investment (FDI). This signals the confidence of foreign investors in India’s growth as well as its democracy and governance. Secondly, since oil is the main import (apart from gold), its international price is within a band of $50-55 a barrel. This is way below the $100 level seen three years ago, and eminently affordable. Indeed this low crude price was the source of a fiscal bonanza to the government, which could utilize the resources to fund social programmes. Hence import of crude is certainly no reason to prop up the rupee.
The rupee’s rise is also being aided by a tight monetary policy, since the higher rates are attracting capital flows into debt instruments. This could easily spiral into a cycle of strengthening a rupee further fueling dollar inflows, causing further strengthening and so on.
This is the nightmare we need to avoid, not just to protect our export competitiveness, but also to ease our rates a bit. In a world veering toward protectionism, India’s exports (and indirectly, its manufacturing base, and the Make In India campaign), need all the help they can get. An unnecessarily and excessively exuberant rupee is the last thing they need to worry about. It’s time the rupee is guided towards a more rational level.
Ajit Ranade is chief economist at Aditya Birla Group.