On rupee strength

Let me state at the outset that I am all for a strong currency PROVIDED economic fundamentals back it up. Strong capital inflows do not constitute ‘sound economic fundamentals’. They are hardly mirrors to fundamentals but of perceptions and that too of the relative variety. So too is the exchange rate. India’s economic growth is middling. It is unbalanced. Private capital formation is still missing. Savings rates have not risen.

So, the currency strength seems to be driven more by perception of India’s strength especially in comparison to other emerging economies, including China, rather than due to intrinsic strengths. That is why, perhaps, RBI has been intervening and that India’s foreign exchange reserves are rising.

This comment is not to take exception to Mr. Ninan’s Op.-Ed today in Business Standard. But, to raise one minor quibble. He had written:

The solution, suggested in this column seven months ago, is to focus on the source of the dollar surpluses: capital inflows, and debt inflows in particular.

Data do not support him – except for the last few months – that India’s dollar debt and equity flows had gone up. If anything, up to December 2016, India’s external debt and Net International Investment Position (IIP) positions have only improved. More repayments (outflows) than borrowings (inflows). Since February this year, India has witnessed strong Foreign Portfolio Investment (FPI) – both debt and equity.

Therefore, the point remains and he is right that India has not earned the right to have a strong currency. Most important of all fundamentals for a strong currency is productivity. India does not have the data because the bulk of the employment in the country is informal. Whether it is 75% or 92%, it does not matter. It is too high.

India is currently not facing headwinds or competitive disadvantage in a big way because other countries, including China, are not actively seeking to depreciate their currencies. That is something to keep in mind and watch out for. Chief Economic Advisor has indeed produced a chart of rising Indian rupee versus the Chinese yuan in his recent VKRV Rao Memorial Lecture. India does have a big bilateral trade deficit with China.

A friend helpfully points out that the focus on the INR/CNY bilateral exchange rate might be a road or bridge to nowhere. He said,

Between 2005 and 2015 the INR depreciated almost 90% against the CNY on nominal basis and about 60% on real effective basis while the bilateral trade deficit went up 24 times from around USD2bn to USD48bn. Not saying currency does not matter but in such cases global supply chains and productivity differentials seem to matter much more than currency divergence.

It is an excellent point. He is very right. I am reminded of what BIS wrote in its 2016 Annual Report on the declining usefulness of exchange rate depreciation for export growth:

Recent studies generally suggest that trade exchange rate elasticities have
declined in response to changes in trade structures, including currency denomination, hedging and the increasing importance of global value chains. For instance, a World Bank study finds that manufacturing export exchange rate elasticities almost halved between 1996 and 2012, with almost half of this decrease due to the spreading of global supply chains. [page 53 – Link]

Second, India’s overall REER has appreciated by about 7% to 9% in the last one year, depending on the metric that one chooses, from among the several that RBI publishes on a monthly basis.

We must remember that REER adjusts for inflation in India relative to that of other countries (trading partners). Inflation is an indirect measure of productivity. Therefore, REER is productivity adjusted in that sense. Even so, the rupee has appreciated in the last one-year or so. That could be a concern for whom export quality or excellence is not a core strength.

But, it has not hurt India much because crude oil has not sustained its price recovery of last year into 2017. This might persist for quite some time. If anything, the risk of further downside for crude oil price is higher than upside for crude oil. That is a good news for India. That is one reason India’s current account is not showing any strain from the rupee strength. Of course, the strength has been somewhat recent only.

It might be then that the Indian interest rates are still too high, relative to that of other countries. Perhaps, RBI is too tight. But, then who knows if India’s inflation has become sustainably low? RBI has not lowered rates because liquidity is otherwise ample, both in domestic financial institutions and from overseas. Their monetary policy might be tight, temporarily, but it has to be shown over time that it has become unsustainably too tight for too long, before the blame can be fully laid at its doors for the strength of the currency.

In sum, the situation calls for observation. The traffic light is amber. It is not red, signalling danger. Those were the days when Germany and Japan could become export powerhouses despite currency strength. It is true that no country depreciates its way to economic prosperity.

In the days of financial globalisation, it is unfortunately and equally true that no country can appreciate its way to external sustainability.

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