Steering between two extremes

India’s current account deficit has jumped to over 4% of gross domestic product (GDP) by some estimates, the highest since Independence. At the same time, the rupee has risen in real (i.e., inflation-adjusted) terms over the last few months, going by the real effective exchange rate (REER) index calculated by the Reserve Bank of India (RBI). The previous biggest external deficits were during the crisis of 1991 (3%) and in 1957 (3.2%) due to the Mahalanobis plan, when policy veered leftward, as Mathew Joseph has pointed out in an article suggestively titled “RBI should act on the exchange rate front” (The Hindu Business Line, 19 April).

More specifically, Shankar Acharya (Business Standard, 22 April) has recommended that RBI resume sterilizing capital inflows to get the REER back closer to its 1994 benchmark value of 100. At the other extreme, Ajay Shah is not against the recent rupee rise (The Financial Express, 1 May). Pointing to the sustained rise in exports (from $2 billion a month in 1995 to $15 billion a month in 2010) he states that “this has nothing to do with exchange rates since the REER is at its 1994 level”, using a different, international measure of India’s REER.

Also See The Ups & Downs of the Rupee (Graphic)

The reader must find it difficult to make sense of these diametrically opposed views, and frustrated with us damned economists. An understandable response, but this vexing exchange rate issue warrants discussion and understanding, since so much is at stake for various trade-oriented firms and workers.

My views are partly in sync with those calling for a weaker rupee now. Nevertheless, for starters, Shah makes some valid arguments. Basic macroeconomic theory, backed by historical evidence, states that, in the long run, the central bank cannot control real variables—in particular, the real interest rate, real growth rate or the real exchange rate. These are determined by underlying fundamentals.

Consider the case of the Western European countries during the 1960s and 1970s. Italy, the proverbial sick man of Europe, would repeatedly devalue the lira to promote exports, but would end up with higher inflation without higher exports. Ditto for the UK, until Margaret Thatcher. By contrast, German macroeconomic policy was concerned only with controlling inflation. Germany ended up being the export powerhouse of the world, and the Deutschmark was strong in both nominal and real terms.

Further, a small currency rise can boost technical progress by forcing firms to innovate to stay competitive, a point that Shah makes. For the Japanese auto industry, there are specific episodes of currency increases that induced them to innovate. When the yen rose from around 240 to 220 against the US dollar in mid-1985, Toyota managers would ask those on the factory shop floor to come up with productivity improvements to enable the company to maintain US dollar prices.

Nevertheless, letting the rupee rise now is bad policy, just as it is bad policy to target the REER. At present, the rupee is strong for the wrong reason—despite a huge current account deficit of $53 billion, due to a bigger capital account surplus of $65 billion (see table). If the rupee rose due to a current account surplus, we should not resist but accept the rise.

Whether a rise in the rupee due to a capital account surplus should be resisted or not depends on the nature of capital flows. If capital flowed steadily into India with viable projects delivering reliable returns, then their influence would be helpful. But we know that this is not the case. Strong surges of capital inflows into emerging markets are followed by sudden stops. This results in a prolonged rise followed by a sharp fall in the currency, thereby damaging the external sector.

Across the world, this has happened time and again, but after September 2008 nobody should need any convincing. Against the dollar, the rupee jumped from 44 to 40 during April-May 2007, as RBI lost control over massive inflows and the call money rate fell at times to zero—a policy fiasco. Then it fell below Rs50 before recovering to about 45 by the end of March (see table). There are other vital arguments for resisting capital inflows, some specific to India, beyond the scope of this article.

Since capital flows are destabilizing, we should impose restrictions through a variety of means so as to keep inflows, say, at around 1% of GDP, and maintain those restrictions. Lower limits for foreign institutional investor (FII) equity holdings, auctioning of quota amounts for External Commercial Borrowings, and Tobin-type transaction taxes can be used to implement such a policy. For feasible control on debt, we should bring down our inflation to a reasonable level (say, 3-5%) and thereby lower rupee interest rates. This will relieve the (most often) one-way pressure for debt inflows at present due to the India-US borrowing cost differential. Those in favour of a weak rupee are strangely silent on the far more crucial matter of reducing inflation.

Our policy needs to steer between the extremes of a rupee gyrating in response to huge capital inflows and swings, and an REER target that is unsustainable and outdated. Indeed, it may not be a bad idea for RBI to deliberately publish its REER tables with a considerable lag, to signal that it should not be given much importance. India will benefit if the rupee is determined by the current account, instead of by fickle international investors. The golden mean can sometimes work.

Graphic by Ahmed Raza Khan / Mint

Vivek Moorthy is professor of economics at the Indian Institute of Management, Bangalore.

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