A stronger rupee can’t slay inflation

India’s foreign currency reserves are now at an all-time high of $541 billion. After allowing the rupee to drop from 75 per dollar to 73, the Reserve Bank of India (RBI) noted last week that “the recent appreciation of the rupee is working towards containing imported inflationary pressures”.

This rare comment on the exchange rate by the RBI has raised important questions: are the growing currency reserves a sign of a healthy external balance? How are these reserves deployed currently, and could India use them more effectively to achieve growth and prosperity? Finally, with so much reserves, should we now let the rupee appreciate, so that inflation softens and our wealth increases?

Fact is, our external balance suffers from a fundamental weakness. Historically, we have borrowed foreign currency and sold ownership in India Inc to global investors to help fund our consumption-oriented imports. This also reflects our structural inability to sufficiently grow domestic output and jobs. Moreover, a significant portion of our foreign currency reserves is made up of opportunistic flows, rather than permanent surpluses.

Periodic entreaties to deploy RBI’s foreign currency assets into “productive” domestic investments make little sense. That said, there should be more transparency and debate around our foreign currency reserve management framework. Foreign currency inflows, and the domestic money they help create, can lead us to growth and prosperity as long as we create sufficient domestic output and jobs.

Finally, allowing the rupee to strengthen further would hardly address inflation. Instead, it would further shift the terms of trade against domestic industry. India needs a more informed currency-monetary framework to replace the opaque manner in which we currently manage our currency and interest rate markets.

The numbers

We need to understand the nature of India’s external balance. Take a look at Chart 1, which depicts foreign currency flows in the 11 years between FY10 and FY20.

Through the period, India net imported goods and services worth $921 billion. Much of this fed domestic consumption, rather than capital formation. In fact, India’s nominal Gross Fixed Capital Formation (GFCF)—a measure of domestic capital investments—grew on average by only 10% annually through this period, compared to 16% during the prior period.

An enduring, large goods and services trade deficit, dominated by consumption rather than capital goods, is the soft underbelly of India’s external balance. This deficit is partly made up by net remittance and transfers of $445 billion from Indian expatriates overseas.

Are high remittances good news? As a domestic parallel, consider states such as Bihar and Uttar Pradesh, which export workers to more industrial states and receive domestic remittances. While migrant remittances are welcome, they also highlight an inability to create adequate local jobs and output. Similarly, at a global level, India exports jobs and workers, and imports goods and services for domestic consumption. Together, net imports and remittances add up to $476 billion of Current Account Deficit (CAD).

Next, India received $301 billion of net Foreign Direct Investments (FDI) during the period. FDI are durable inflows that ideally create quality jobs and output in the country, bringing in technology, know-how and international best practices. Together, CAD and FDI represent permanent currency outflows of $175 billion during the period.

The above permanent deficit was partly made up by $141 billion of Foreign Portfolio Investments into equity markets (FPI equity), where we sold part ownership of India Inc to global equity investors. While such FPI equity flows support domestic equity markets and investor wealth, their translation into jobs and output is more tenuous in comparison to FDI flows. Over time, FPI equity investments have grown in value to $371 billion of equity assets under custody, representing over 55% of NSE NIFTY market capitalization.

Finally, the balance $159 billion of “carry” flows are repayable, reversible and opportunistic. Relatively high rupee interest rates may attract investors to hold rupee assets, or borrowers to hold foreign currency liabilities. Examples of “carry flows” include unhedged foreign currency borrowings by domestic entities, investments by FPIs and Non-Resident Indians (NRI) into Indian debt, and forward sales of forex by exporters and speculators.

Put together, the RBI net purchased $125 billion of foreign currency through market intervention.

Of course, the nature of the external balance has changed considerably though covid-19. For now, our domestic consumption and net imports have collapsed. As a result, our current account balance for FY21 could end in a surplus of $20 billion. Alongside FDI and FPI flows, the RBI may have to purchase over $70 billion of currency inflows through the year. When some semblance of normalcy returns, however, the nature of the external balance could revert to past trends.

The takeaways

Over time, we have borrowed money (carry flows) and sold ownership of India Inc (FPI) to fund our consumption import bill, rather than to fund capital investments. Here, our external balance is sadly similar to our fiscal balance. On both fronts, we sell family silver and borrow from our children’s future to finance our consumption needs.

Our permanent currency flows were negative between FY10 and FY20. The entire $125 billion of RBI intervention purchases was made up of opportunistic, reversible, “carry” flows of $159 billion. The quality of our reserve build-up is poor, in relation to countries such as China, where the reserve build-up results from permanent flows. Our persistent large net import of goods and services for consumption is a troubling indicator of our inability to ramp up domestic production to at least match domestic consumption. Given this nature of our external balance, there is a need for a conservative strategy around reserves management. For one, we need to import critical items such as crude oil. For contingency planning, this calls for a buffer, preferably in the form of crude oil reserves, rather than currency or gold reserves.

More generically, we need our external debt to be rolled over smoothly. As of March 2020, our external debt across commercial borrowings, portfolio and NRI debt investments and trade facilities stood at $558 billion, against foreign exchange reserves of $477 billion. A conservative reserve management strategy is important to instill investor confidence, and ensure our ability to maintain, extend and roll over our debt.

One suggestion that periodically comes up is that the RBI should somehow use our foreign currency reserves to promote infrastructure investments in India. Such proposals make little sense. We do not need the backing of RBI’s foreign currency reserves to justify creation of domestic credit or money. India’s financial services ecosystem should fund commercial activities and create money. Inefficiencies in this ecosystem need to be addressed separately, rather than have the RBI take up commercial roles. The RBI anyway stands ready to supply foreign currency to markets, to fund these requirements as necessary.

One area where there is insufficient transparency and accountability is around the investment outcomes from the management of our foreign exchange reserves by the RBI. Understandably, RBI maintains considerable secrecy around how reserves are invested at any point.

However, given the materiality, there should be disclosures (with a lag) around the asset allocation adopted across different currencies, portfolio returns against benchmark returns, and portfolio risks. Such disclosures can spark an informed debate about the best way for the RBI to manage the portfolio on an ongoing basis.

Net foreign currency inflows create rupee deposits and money supply – just as banking loans and government fiscal deficits do. Good quality money creation is a key element to a virtuous monetary-economic cycle, leading to prosperity and growth. This is how an ideal cycle should work. As domestic money created from foreign currency inflows circulates in the system, economic activity would ensue. Investment activity would create capacity, jobs and output. As the money flows into the hands of consumers, consumption and demand would arise. A virtuous cycle of increasing output, jobs, savings, and investment would perpetuate.

The key element for such a sustainable monetary-economic cycle is that domestic output should at least match domestic demand, if not actually exceed it through net exports. Money and economic growth can then be sustained without domestic inflation or currency weaknesses.

By ensuring that domestic output well exceeded domestic demand, China maintained such a virtuous monetary-economic cycle for decades. This has allowed China to grow household and private domestic debt to 240% of its GDP, without undue worries on inflation, external imbalance or financial instability.

In comparison, we have faltered on our domestic output and jobs front. We continue to net import goods and services for consumption. Any increase in money supply and consumption, without a concomitant increase in domestic output, risks inflation and external imbalance. Even with private debt at just 65% of GDP – a fourth of China’s level - we worry about the consequences of excessive money supply on financial stability.

Ultimately, the key to putting India’s monetary-economic cycle on track, and hence to fully utilize the benefits of currency inflows, lies in addressing real sector issues that come in the way of domestic jobs and output creation.

The stronger rupee

The RBI has often glibly stated that it does not target any rupee level, and that it only intervenes to control currency market volatility. Make no mistake though -- where the rupee settles now is entirely dependent on RBI’s intervention strategy.

Should INR be allowed to appreciate more to bring down inflation? On inflation, the RBI’s own models indicate that for every 5% appreciation of the rupee, inflation reduces by barely 0.2%.

On the other hand, a relatively stronger rupee would only shift the terms of trade further away and encourage imports when our consumption resumes, at the cost of our fragile domestic industry. The 36-country trade weighted Rupee Real Effective Exchange Rate (REER) shows that rupee continues to be overvalued.

From a monetary policy perspective, the current abundant permanent currency inflows do make the case for very low short-term rupee interest rates. Low rupee interest rates would deter investors from moving from foreign currency to rupee assets, since the “carry” earned from holding Rupee assets is not attractive enough. It might also nudge domestic borrowers to borrow in rupee, rather than in foreign currency.

Both of these would result in lower opportunistic “carry” inflows of foreign currency, at a time of abundant currency inflows.

To be sure, there is a deep connect between monetary policy and external balance. These interconnections cannot be wished away simply by mandating a blinkered framework. That’s why we need a comprehensive currency-monetary framework to replace the simplistic repo rate-inflation dogma that we currently espouse.

Ananth Narayan is associate professor, SPJIMR