Why the exchange rate is always subordinate to inflation

According to news reports, recent remarks by the governor of Reserve Bank of India (RBI) Raghuram Rajan focused on the trade-off between inflation and external competitiveness with respect to the rupee’s exchange value. A depreciation or weak currency may not necessarily boost exports, he said, but would certainly have inflationary consequences by pushing up import prices. He additionally referred to the deliberate currency undervaluation policies pursued by some of India’s neighbour countries for long periods of time; this, he said, required repressing their financial systems.

The governor has raised relevant economic policy issues. However, the link between export competitiveness and currency value is hard to consider and incomplete without a reference to the historical evolution of India’s exchange rate policy and especially so after opening of the capital account. What for example, might current production structures have been had currency overvaluations been altogether avoided in the ‘managed floating’ era or even before? For the brief period that an active rupee devaluation policy was pursued in 1986-90, the ensuing real depreciation did stimulate exports, further supported by subsequent major devaluations of 1991-92. But the paucity of space limits this side of the argument.

Focus therefore upon inflation and the long-time subordination of India’s exchange rate policy to this cause. India stands apart historically from its emerging market peers in this regard. While the latter group trained their exchange rate policies to build domestic manufacturing bases and expand their tradable sectors way back in the sixties and seventies, India was busy repressing its exchange rate, that is, keeping it relatively overvalued, to ward off imported inflation. It is important to underline here that a competitive exchange rate need not be deliberately ‘undervalued’; but it is certainly not ‘overvalued’ either.

Whereas the other countries, e.g. China, could address domestic inflation through aggressive supply-side reforms in their early stages of development—especially in agriculture to keep food prices low—India failed to do so beyond the Green Revolution in the sixties. As substitute, exchange rate movements were manoeuvred, motivated by anti-inflationary considerations (indeed, the RBI reports in the late seventies stated as much!). Exchange rate based stabilization has by far been the easier option, including politically. Throughout the past decades, periodic exchange rate corrections, often forced by external events, have been downwards. These were discrete in the sterling and basket-peg days; with a more flexible exchange rate policy, the adjustments have been mostly orderly, steady and continuous (except 2011-13, where the preceding deviation to a floating currency-no reserves’ accretion no doubt played a role). Nonetheless, these currency adjustments have never been sufficient to achieve external balance, as evidenced from the persistent current account deficits. Why? Because inflation worries limited the realignments!

Now, with an inflation targeting framework that has tight links to central bank commitment and credibility but still with no permanent resolutions to fundamental price problems through structural changes, the bonds to the currency are closer than ever. Over the years, import dependencies have both broadened and deepened. Which is why the exchange rate seems doomed to be forever subservient to the inflation objective. Unless of course, there are aggressive and large-scale reforms to expand supplies of both agriculture goods and many of the services whose demand is fast increasing.

Renu Kohli is a New Delhi based economist.