In 1991, when India commenced her economic reform programme, there were really three players in the foreign exchange markets – the Reserve Bank of India, the State Bank of India and Indian Oil. Between them, they generated the bulk of supply and demand for US dollars and created the fundamentals of a foreign exchange market. Minor movements of the rupee – even by a few paisas – created news and alarm. However, things are very different today. Volatility has increased considerably and variances of 20% over a short period of a few months are not uncommon.
Many economists believe that the rupee, despite its recent bear hammering, remains over-valued. Based on the Real Effective Exchange Rate Index, they argue it should trade at approximately 52 to the US dollar at the current juncture. The crux of their argument stems from the fact that India’s exporting community would become uncompetitive in the face of a strong currency. Healthy capital inflows have, in the past, kept the Balance of Payments in surplus and therefore, despite trade imbalances, the rupee has remained steady or indeed, gained a little against the US dollar. In my view, allowing the currency to depreciate to such values would be a folly.
India’s economic architecture is based on domestic private consumption. It is fundamentally not an economy designed to be export-competitive. If that had been the case, then wages would be artificially curbed, as would private consumption; input costs would be kept synthetically low and the government would channelize private savings towards the creation of infrastructure. Businesses would build large factories to churn out widgets in vast numbers at very competitive rates and export them to other countries. This is precisely what China has done over the past twenty years. Its private consumption is around of 35% of GDP – a ludicrously low figure. In most countries, including India, private consumption usually exceeds 55% of GDP (71% in the United States).
Allowing India’s currency to depreciate theoretically helps exporting organisations, as it adds to their profit margins. The question is does it really make them more competitive? Does it help India? The answer to both, beyond doubt, is no. There is evidence to suggest that larger margins and greater profitability pushes businesses into complacency. They allow input costs to rise – for instance, they become more generous with salaries and bonuses; they are prepared to pay higher rents for their offices; establishment and administrative expenses are generously provided for, etc. Builders command larger premiums of office premises, suppliers get away with heftier margins, and so on. In effect, an environment of high inflation is created. A depreciating currency does it all for them. If, on the other hand, the currency was to strengthen, then the margins and profitability of exporting companies would come under pressure. They would have no choice but to curb expenses and keep administrative costs under check. Consequently, in a macro sense, price stability is maintained and inflation is curbed.
Previous surveys undertaken by IMA actually suggest a much higher tolerance threshold for a rising currency. Several exporting companies in the services sector remain competitive even when the exchange rate is around 42 to the US dollar. An exchange rate of 49 could simply give some of them money to fritter away.
A weak currency is a recipe for imported inflation. Oil, coal, minerals and other consumables become expensive. These cost rises are ultimately passed down to the consumer, resulting in an overall rise in the cost of living. We believe that India’s growth in the coming decade will be driven through massive investments in infrastructure and new capacities in manufacturing. Both require large imports of capital goods and commodities. A weak currency only hikes the price of these imports and therefore, the initial capital outlay for a new project is consequently higher. When these projects go into operation, they are forced to pass on these higher costs to end-users. Therefore price rises are bound to follow.
Some economists, on the other hand, legitimately argue that a weaker currency would provide a fillip to domestic manufacturing. For example, imported capital goods may become more expensive than domestically produced ones, effectively driving greater domestic sales. However, on balance, I subscribe to the hypothesis that it is still better to have a stronger currency and control inflation, even if that came with some disadvantage to domestic manufacturing. There is again evidence to suggest that the more capable companies find innovative means to reduce their costs through the adoption of new technology, manufacturing processes, product design etc. In any event, even local producers do need to import raw materials or semi finished products and a stronger currency keeps such costs under check.
Adopting the China model may not have been a bad thing. But it may be a bit late for India to restructure its economic fundamentals. High wages, private consumption, unusually high establishment costs (rent, electricity, etc) are now a given and India needs to design its monetary and exchange rate policies to fits its economic architecture. Radical changes come with unacceptable shocks to the system which may be hard to implement. Even China now seeks to reorient its economy and hopes to increase private consumption to about 40% of GDP by 2015. In order for this to happen, it would have to allow wages to rise, therefore providing an incentive for its people to spend more; its currency to strengthen and facilitate the creation of a domestic market. Even in China, export-driven growth, which happily puffed along for two decades will begin to falter as European and American consumers deleverage – spend less and save more. This comes with serious consequences for Chinese producers.
Ultimately, the movement in exchange rates is something determined by supply and demand and the vagaries of financial markets. Some economists are possibly right when they argue that the rupee will weaken in the coming decade. However, if that were the case, then inflation would convert into a recurring and stubborn problem. Ultimately, what will change the picture is the resumption of capital inflows and this will happen when the current policy paralysis gives way to efficient governance and a pro-active administration seeking to make things better. The fate of the Indian rupee over the next decade will depend as much on the quality of India’s political leadership.