On 5 April, the Reserve Bank of India (RBI) cut the rate at which it lends to banks on the short-term loan market by 0.25% and introduced a host of measures to smoothen liquidity supply.

The reduction in interest rates is believed to be important because, if it is reflected in lower lending rates, it can kick-start the sluggish domestic investment cycle. However, the challenges of the domestic investment cycle are far too severe for an interest rate reduction, certainly one of this magnitude, to make an impact. The problems include a gloomy world economic scenario, over-leveraged corporate balance sheets and an extremely weak rural demand.

Ninety-five per cent of India’s investment comes from domestic sources. Further, a significant portion of foreign direct investment (FDI) into India is believed to be domestic capital round-tripping via tax havens like Mauritius. Hence, even a doubling of FDI may not suffice to bring about the stimulus needed. The government is limited in its ability to inject a fiscal stimulus because of the threat of inflation. In this situation, foreign markets offer a thin sliver of hope for Indian business. Hence, the efficacy of the rate cut should be seen not in terms of its impact on domestic investment but on foreign demand, through the channel of its impact on the exchange rate. Lower foreign demand for Indian assets following the rate cut would be the channel through which the rate cut would depreciate the currency.

In response to criticism that India’s currency was overvalued, RBI governor Raghuram Rajan has argued that if the growth of India’s productivity is factored in, the rupee ceases to be overvalued.

The Balassa-Samuelson theory that is the theoretical basis for Rajan’s stance, considers a country with a tradable (i.e. bought and sold in world markets) and non-tradable goods sector and establishes that, given well-functioning labour markets and efficient world markets where tradable goods command the same price across countries, a higher productivity differential between tradable and non-tradable sector of the home country vis-à-vis other countries would lead to a higher price for the non-tradable good in the home country. The real exchange rate of rupee measured in terms of a foreign currency, say the dollar, is the nominal exchange rate (number of rupees per dollar) multiplied by the ratio of price index in the US to the price index in India. The appropriate measure of inflation that should be used to derive the real exchange rate would be one that restricts itself to tradable goods. Thus, by using the consumer price index (CPI) that includes both tradable and non-tradable goods, the home currency would appear to be stronger than it actually is in terms of real purchasing power. Hence, the argument that the rupee should be further weakened is not justified.

Although carefully nuanced, the argument by the RBI governor regarding application of the Balassa-Samuelson model to the Indian scenario requires a number of supporting conditions to hold true.

First, the premise that India enjoys higher productivity growth as compared to other nations needs examination. Conventional theory suggests that developing countries have greater scope of improvement and thus have higher productivity growth as compared to already developed nations. However, as per the global research association The Conference Board’s 2014 data, labour productivity growth in India at 3.2% is lower than in China (7%), Myanmar (6.1%) and Indonesia (5.9%), although higher than in South Korea (1.5%), US (0.7%) and Europe (0.5%). These numbers do suggest that a more detailed analysis is required to support India’s higher productivity growth claims.

Second, if wages in the non-tradable goods sector are sufficiently lower than those in the tradable goods sector, then the conclusions of the Balassa-Samuelson model could be overturned. A working paper Is the Rupee Over-valued? by Jaimini Bhagwati, Abheek Barua and M. Shuheb Khan (2015) states, “the channel of transmission of wage inflation from the tradables to the non-tradables sector could be weak given that the skill sets needed for tradables and non-tradables are widely divergent". The presence of a large unorganized sector in non-tradables makes the equalization of wage rates across sectors even more unlikely. The fact that it is possible to get a haircut in India at 30 should give us pause when we apply the Balassa-Samuelson theory here.

Finally, the law of one price that states that tradable goods should be similarly priced (modulo transport costs) does not hold given the various tariff and non-tariff barriers applicable in today’s trade environment.

Therefore, the argument that the rupee is already sufficiently weak in real terms, and does not require further depreciation may not hold water. It is possible that the RBI governor ‘doth protest too much’ as the central bank is keen to protect the value of the rupee in order to promote foreign investment, which might not be forthcoming if the exchange rate is left to depreciate a lot. However, as already elaborated, FDI has limited impact on the domestic investment cycle. Even portfolio investment, while it can prop up stock prices, is unlikely to promote primary investment, unless business conditions improve drastically.

The main advantage of lower interest rates is not the direct benefit of lowering cost of funds, but the impact on lowering India’s exchange rate, thus triggering demand for our exports. It is time for India to focus on securing foreign markets instead of fishing for foreign investment.

Rohit Prasad and Shashank Gupta are, respectively, professor, and a recent graduate from MDI Gurgaon. Comments are welcome at theirviews@livemint.com

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