Rupee strength is unjustified
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The strength of the Indian rupee is a hot topic. It is a source of pride for some. It is a concern for others. Let me state at the outset that I am all for a strong currency provided the economic fundamentals back it up. Strong capital inflows do not constitute “sound economic fundamentals”. They are hardly mirrors to fundamentals but they reflect investors’ perceptions, and that too of the relative variety. So too the exchange rate. India’s economic growth is middling. It is unbalanced. Private capital formation is still missing. Savings rates have not risen. But the trade deficit is rising.
India published its April trade numbers on 15 May. The merchandise trade deficit is up sharply. Imports during April 2017 were 49.1% higher in dollar terms and 44.7% higher in rupee terms over the level of imports in April 2016. Excluding the crude oil, imports during April 2017 were 54.5% higher than non-oil imports in April 2016 in dollar terms. Exports were higher by nearly 20% compared to a year ago but they were easily outpaced by the growth in imports. Consequently, merchandise trade deficit in April was 173.5% higher than a year ago in April 2016.
This should not be surprising for many reasons. One, this is what a strong currency does. It makes imports more attractive. Two, any developing economy that is growing briskly tends to attract more imports. Third, it is also a sign of the relative uncompetitiveness of domestic manufacturing relative to goods made elsewhere. In general and in rational financial markets, this news should be negative for the Indian rupee. But the rupee has stayed firm after appreciating in the last several months. India has not earned the right to have a strong currency. Most important of all fundamentals for a strong currency is productivity. India does not have the data because the bulk of the employment in the country is informal.
India is currently not facing headwinds or a competitive disadvantage in a big way because other countries, including China, are not actively seeking to depreciate their currencies. That is something to keep in mind and watch out for. Chief economic adviser Arvind Subramanian had produced a chart of the rising Indian rupee versus the Chinese yuan in his recent VKRV Rao Memorial Lecture. India does have a big bilateral trade deficit with China.
However, the focus on the rupee/yuan bilateral exchange rate might be a road or bridge to nowhere. Between 2005 and 2015, the rupee depreciated almost 90% against the yuan on a nominal basis and about 60% on a real effective basis while the bilateral trade deficit went up 24 times, from around $2 billion to $48 billion. I am not saying currency does not matter but in such cases global supply chains and productivity differentials seem to matter much more than currency divergence.
The Bank for International Settlements wrote in its 2016 Annual Report on the declining usefulness of exchange rate depreciation for export growth: “Recent studies generally suggest that trade exchange rate elasticities have declined in response to changes in trade structures, including currency denomination, hedging and the increasing importance of global value chains. For instance, a World Bank study finds that manufacturing export exchange rate elasticities almost halved between 1996 and 2012, with almost half of this decrease due to the spreading of global supply chains.
Second, India’s real effective exchange rate (Reer) has appreciated by about 7% to 9% in the last one year, depending on the metric that one chooses, from among the several that the Reserve Bank of India publishes on a monthly basis. We must remember that Reer adjusts for inflation in India relative to that of other countries (trading partners). Inflation is an indirect measure of productivity. Therefore, Reer is productivity adjusted in that sense. Even so, the rupee has appreciated in the last one year or so. That could be a concern for India’s external balance since India’s exports are mostly price-sensitive and not high value-added goods whose utility matters more than price for buyers.
Luckily, India’s merchandise trade deficit has not ballooned because crude oil’s price recovery in 2016 has not been carried into 2017. This might persist for quite some time. If anything, the risk of a further downside for crude oil prices is higher than an upside. That is good news for India. That is one reason India’s current account is not showing any strain from the rupee’s strength. Of course, these are early days.
The rupee’s near-term strength might be because Indian interest rates are still too high relative to that of other countries. Perhaps, the RBI is too tight. But then who knows if India’s inflation has become sustainably low? The implementation of the goods and services tax, going by international evidence, can result in a one-time boost to prices. India’s monetary policy may indeed be tight, temporarily, but it is still premature to argue that it has become unsustainably too tight for too long, and thus blame it for the strength of the currency.
Those were the days when Germany and Japan could become export powerhouses despite currency strength. It is true that no country depreciates its way to economic prosperity. In the days of financial globalization, it is unfortunately and equally true that no country can appreciate its way to external sustainability. In sum, it might be dangerous to bask in the strength of the Indian rupee.
V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. These are his personal views.
Read Anantha’s Mint columns at www.livemint.com/baretalk. Comments are welcome at firstname.lastname@example.org.