English economist Joan Robinson once remarked that for every statement about India, the opposite is equally true. It may well be said of exchange rates too. For every theory of exchange rate behaviour, the opposite is equally true. That is why it is often said that for exchange rate forecasts of less than a three-year horizon, one is better off simply tossing a coin and making a prediction. Fundamentals work better at horizons of 36 months and longer. Take the Indian rupee for example.
Between 2009 and 2012, the rupee did not depreciate against the US dollar. During this period, the Indian inflation rate was in double digits and the inflation rate in America was around 2%. The rupee, as per relative purchasing power parity theory, must have depreciated around 7% to 8% every year. It did not. That meant the rupee was appreciating in real terms and becoming uncompetitive. Throw fiscal deficits and current account deficits into the mix and one had the perfect trifecta for the currency to weaken substantially. It did so in 2013.
Around the 71st anniversary of India’s independence, the rupee too crossed the 70 mark against the US dollar. Social media chats were buzzing with concerns about the Indian rupee and the incongruity of the currency losing value as the country was celebrating its independence day. There is a mistake in confusing a strong currency for a strong economy. For small, open economies, currencies are more important in determining the ebb and flow of economic growth than they are for large economies. For the latter, the currency is more of a mirror to the economy than an influencer. Therefore, currency weakness is a sign of underlying economic fragility. India’s inflation rate may not be high by historical standards but it is high in comparison to developed nations. So, the currency’s default trajectory has to be one of weakness. Otherwise, it will be appreciating in real terms and that is not good for an economy. A currency that is overvalued in real terms makes imports attractive and exports uncompetitive. In the long run, exchange rate changes reflect inflation differentials.
Therefore, to fret over rupee weakness is a mistake. It is right to fret about India’s rising non-oil, non-gold imports. It may not be correct to focus on India’s bilateral trade deficit with China but it is right to be concerned about the overall trade deficit. It reflects an economy that is consuming more than it produces. It reflects an uncompetitive economy for it makes more sense to import than to buy domestically produced goods or that domestic production of some goods does not happen, or it is a combination of all of these. These must be worrisome. Currency strength without underlying economic resilience is not a cause for celebration but cause for concern. Like stock market bubbles, it won’t sustain.
India faces three immediate worries and it would take more than this column to write about long-term concerns. In any case, this column has been writing about enduring issues regularly. The immediate worries are the potential for correction in US stocks, rising interest rates in America that make dollar borrowing costs expensive and the strength of the dollar. A significant correction in American stocks is overdue. When that happens, emerging market stocks will not be exempt. BSE 100 stocks dropped nearly 30% in two months between April and June 2006 and between January and October 2008, the index lost two-thirds of its value. Interest rates in the US are poised to keep rising this year and that raises dollar funding costs. India’s short-term external debt (residual maturity of less than one year) amounts to more than 40% of total external debt as of March 2018. Of course, not all of it would be called. About $60-100 billion might be rolled over but additional financing has to be found not only for the trade deficit but also for debt repayments. That puts pressure on the rupee. Finally, US dollar strength exposes the underlying vulnerabilities of emerging currencies. Contagion follows. That was another factor behind rupee weakness in the last few weeks. As the Turkish lira slumped due to political and economic risk factors, other emerging currencies, including the Indian rupee, fell in sympathy.
In this milieu, one must view India’s trade balance report for July with concern. While the higher price for crude oil this year is a large part of the explanation for India’s higher trade deficit between April and July 2018 ($171.2 billion), compared to April-July 2017 ($146.3 billion), non-oil and non-gold imports in this four-month period were higher by 10.7% over the same period last year. India’s overall fiscal deficit (including state governments) was 6.5% of gross domestic product (GDP) for 2017-18 as per official numbers.
Interestingly, the International Monetary Fund puts the federal government deficit at 4% as per its calculation that excludes asset receipts. That puts the general government deficit at 7% of GDP. As the private sector finds its mojo, one hopes that the government throttles back on its spending. But, election year priorities might dictate that the government does not take its foot off the fiscal pedal. That means an overheating economy showing up in higher inflation and/or higher current account deficit. All of these mean unrelenting pressure on the Indian rupee. More on what to do about it in future columns.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk.
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