Photo: Bloomberg
Photo: Bloomberg

India needs a weaker exchange rate

Currency has been one of the policy tools used by various countries to encourage domestic businesses

One of the key things about the Indian economy in the past two years has been a relatively stable rupee. While a stable rupee may be a cause for celebration, it comes at an economic cost—the relative appreciation in the rupee’s real value. As other countries’ currencies have fallen due to slowing economic growth or loose monetary policies, they remain reasonably competitive. In our case, however, the rupee has become stronger, impacting our overall global competitiveness.

Many economists consider the ‘fair’ value of the rupee at around 72-73 against the dollar, which means the rupee is ‘overvalued’ by 6-8%. If we have inflation of 5% in the coming year, then by 2017, the fair value should be about 75-76. Add to this a ‘pre-emptive’ weaker currency for competitiveness, as highlighted above, rupee value of 80 to the dollar is actually not unthinkable. While this further depreciation in the rupee may sound alarming, it will actually benefit the economy. Currency has been, and continues to be, one of the policy tools used by various countries across time periods to encourage domestic manufacturers.

The global overcapacity affects us deeply as we are now part of the interconnected global supply chain. The historic argument about weak currency for export growth has another equally important import dimension to it. As our currency has become stronger, our import dependency will increase, putting stress on local manufacturing. We are already seeing this in the steel and chemicals sector. Even in the agricultural sector, the overvaluation of the rupee is hurting farm incomes. This can be seen in the case of wheat, where the government had to resort to import duties as domestic prices had become uncompetitive. A sharp fall in the currencies of Argentina, Brazil, Russia and Europe has helped these countries in pushing exports of agricultural commodities at far cheaper rates than we can produce locally.

The world is increasingly moving towards reduction in trade barriers. India is considered to have the highest tariff barriers already as our tradable sectors have been hit by dumping from overseas. Increasingly, our ability to use tariffs as a way of equalizing the appreciating rupee will have limited scope. A weaker rupee will have the same impact as import tariffs without upsetting our World Trade Organization commitments. Also, a falling rupee will give some protection to local manufacturing—both for India’s consumption and some degree of export competitiveness. Therefore, we should move from using tariff to using currency as a key equalization tool.

China has been able to effectively use its currency strategy for many years. The advantage that an aggressive currency strategy confers on a country is more permanent than tariff barriers. At 80 to the dollar, our steel sector can get back to good health and many of the woes that plague this sector will reduce.

There are arguments that we should improve our core competitiveness rather than use currency as a tool to defend ourselves—the same arguments can be used for tariff barriers. But the ground reality is that Indian manufacturers have certain disadvantages like high land costs and lower labour productivity which result in higher production costs compared to our global peers. Some of these are due to past policies, some due to inherent Indian inefficiency, and some due to structural reasons such as high inflation. Improvement in competitiveness will come over the next few years (as government initiatives on ease of doing business, Skill India and Digital India take shape) but in the meantime, to offset these structural costs, we need a weaker rupee.

Many Indians have the dual misconception that a stronger rupee is a matter of great pride and a falling currency is shameful. There is this well-known anecdote (as recounted by Jairam Ramesh in his recent book To the Brink and Back: India’s 1991 Story) about the political opposition to the rupee devaluation in 1991. The devaluation was planned in two stages but after stage 1, there was so much political uproar within the Congress party that then prime minister P.V. Narasimha Rao asked finance minister Manmohan Singh to cancel stage 2 of the devaluation. But by then, the Reserve Bank of India had already announced it.

However, most countries do not share this notion. In Japan, whenever the yen falls, the Nikkei index goes up. The US has tried for many years to force China to appreciate the yuan, which China has resisted. In a world of overcapacity and weak demand, a strong currency is not a matter of pride, but a source of concern.

As with everything in economics, this will come at a cost. Any policy tool is about trade-offs. A falling rupee will put pressure on inflation. But with weak global commodity prices and a vigilant central bank, we may be able to manage this. There will also be stress among corporates who have borrowed in foreign currency and not hedged as they will be hit hard.

What we need is a gradual depreciation over the next 12-18 months and as the markets and investors see the trend, they will adjust. Right now, there is an almost free carry trade wherein investors can borrow in dollars and invest in the high-yielding rupee. Many Indian corporates are also using this arbitrage via foreign currency borrowing which is not hedged (as post hedging cost, the interest rate differential narrows considerably).

A falling rupee offers a triple action since it is equivalent to cutting interest rates, extending import tariffs and providing an export incentive—all in one. A weak currency strategy will have the same matrix of cost benefits, but overall at this stage in our economic evolution and the global macroeconomic outlook, the benefits of a weaker currency outweigh the costs.

Rashesh Shah is chairman and chief executive officer, Edelweiss Group.

Comments are welcome at theirview@livemint.com

Close