Will a weaker rupee help India?

The slowdown in India’s economic growth in the first quarter of the current fiscal year (April — June 2017) to 5.7% from 7.3% in the previous quarter has led to calls for lower interest rates and cheaper rupee. Without a careful and deliberate diagnosis of the underlying economic issues, prescribing such standard remedies might be counterproductive.

First, is the rupee overvalued? Computing the Purchasing Power Parity (PPP) exchange rate of the Indian rupee bilaterally against the U.S. dollar is not a straightforward task thanks to the difficulty in obtaining a long-enough time series of prices in India with a single base year. Further, there are problems with components and weights in the Wholesale Price Index and Consumer Price Indices for rural and urban consumers. So, I used OECD data (quarterly data for twenty years) on Gross Domestic Product price index (GDP deflators). At the current exchange rate of 65.53, the rupee is about 8.3% overvalued against the U.S. dollar. One could put it down to statistical margin of error. It is not egregious.

Source: OECD database

Of course, trade is conducted with many countries and hence, effective exchange rates matter more than bilateral exchange rates. The real effective exchange rate (REER) of the Indian rupee as per data from the Bank for International Settlements (BIS) has appreciated by 17% since the present National Democratic Alliance (NDA) government took office in May 2014. It is significant at one level. However, since the index is set to 100 in the year 2010, the appreciation since 2010 is around 12%. Moderate but not concerning. As per data from the Reserve Bank of India (RBI), the REER has appreciated less (around 10%) since May 2014 whether it is trade-weighted or export weighted. The base year for RBI data is 2004–05.

Export growth has many causative factors. Empirically, over the years and across nations, it has been found that income effects (growth in importing countries) dominate price effects (exchange rate change). India’s merchandise exports surged 2.5 times and export of software services more than trebled in dollar terms between 2004 and 2008 despite rupee appreciation of about 20% against the dollar in that period. The REER of the Indian rupee, as per RBI data, had appreciated by about 10% too.

As a bloc, India’s biggest trading partner is the European Union. ​​India’s trade with Europe is instructive for two reasons. First, in the years in which the euro was much stronger and the Indian rupee had plummeted (2012–13 and 2013–14), India’s exports to the European Union hardly grew because the Eurozone economies were struggling then. ​Again, it underscores the relevance of economic growth in the importing region for exports than the exchange rate.​ Second, in the last two years, the euro appreciated more against the dollar than the rupee has. From around 1.05 (euro-dollar), it strengthened to 1.20. That is a 14% appreciation. During the same period, the rupee strengthened against the dollar by less than 5%. Further, European economic growth rebounded​in this period. Yet, India’s export to the Eurozone (in euro terms) picked up by only 7%, despite the price and income effect working in India’s favour. ​What gives? Low productivity stands in the way of India’s export competitiveness.

The Nominal Effective Exchange Rate (NEER) of the Indian rupee is below 80 as per RBI calculations. BIS data shows the same. In other words, in nominal terms, the rupee is competitive. It is India’s historically higher inflation than that of the average inflation rate of its trading partners that causes REER appreciation and export uncompetitiveness. That is a problem to be fixed with productivity improvements, better infrastructure and easier operating conditions for businesses and people. In a recent interview, the Vice-Chairman of NITI-Aayog has done well to highlight, for example, the need to reduce turnaround time in Indian ports. The Prime Minister must spearhead a campaign similar to ‘Swachh Bharat’ for improving labour productivity in India — in and outside the government.

There are other steps that the government can take, to improve productivity. The government should not be obstructing scale efficiencies. The NITI-Aayog report on the ‘Ease of doing business’ in Indian States published in August 2017[1] points out that “firms with more than 100 employees took significantly longer to get necessary approvals than smaller firms with less than 10 employees. Large firms were also more likely to complain that regulatory obstacles were a major impediment to doing business. They are also more likely to report incurring higher costs for getting necessary approvals. The experiences and grievances of large firms indicate that it remains very hard for firms to scale up or grow in size. This could explain why firms in India are overwhelmingly small and remain small.” It is one thing to nurture micro and small enterprises with positive measures but making operations difficult for bigger enterprises is bad for productivity and undermines export competitiveness.

There is an even bigger danger from a weaker rupee with respect to the import of machinery and transport equipment — capital goods that India needs to ramp up its production and improve its productivity and potential growth. It makes them expensive. India will import less of them consequently, denying opportunity for productivity and quality improvements for businesses. That is the evidence from the last seven years.

Five categories of imports — machine tools, machinery, electrical & non-electrical, transport equipment, project goods and professional instrument, optical goods, etc. –fall under ‘Machinery and Transportation Equipment’. These are taken from Table 130 of the Handbook of Statistics of the Indian Economy from the website of the Reserve Bank of India.

Imports (USD million) under these five heads in each of the last five years have been as under:

There has been a big fluctuation in the value of the Rupee versus the US dollar in this period. So, we may be spending more in rupee terms but the dollar price may not have changed much. In other words, the dollar value does reflect the fact that we may be importing less of them either because they are now more expensive in rupee terms or because the economy might not be doing well or both. The quantity index of imports under the category, ‘Machinery and Transport Equipment’ confirms the above observations.

Source: Table 138 of the Handbook of Statistics on the Indian Economy, Reserve Bank of India

The above chart is as important as it is dramatic. Quantum of capital goods imports has dropped substantially even as their unit value has gone up substantially, presumably because of the rupee weakness. So, the more rupee weakens, the less we import of these goods and, consequently, India adds less and less to its productive capacity and potential. So, paradoxically, we will be importing more of the goods that would be produced locally with these machinery, otherwise. So, rupee weakness will make us import less of what we need and more of what we would otherwise be producing internally!

India’s net international investment position is USD(-)406bn as of June 2017. Liabilities on account of debt securities, trade credit and loans constitute USD345bn. If the rupee depreciated by 2%, these liabilities go up by USD7bn (in Rupee terms) straightaway. The challenge is to make sure that export gains are at least USD7.0bn for the net benefit of the exercise to be worth it. Evidence and arguments presented above suggest that export gains are unlikely to come by easily.

Finally, the Federal Reserve looks set to raise the Federal funds interest rate at least once this year and more in 2018. It is also determined to reduce the size of its balance sheet by selling U.S. Treasury securities it holds or by nor buying more to replace maturing debt. That could push up long-term interest rates too in the United States. Anticipating these, the U.S. dollar, which has weakened since President Trump took office, has reversed course in recent weeks. Further, the political future of the Eurozone and consequently its economic stability too has come under a cloud after the German election and the controversial non-binding independence referendum in Catalonia in Spain. With these developments, uncertainty has returned to the foreign exchange market. That favours the US dollar. Therefore, the rupee might weaken without any effort on the part of India. It is better to let the market do the job. Deliberate engineering of currency weakness might damage credibility and hard to earn it back easily.

In the final analysis, the external value of a currency mirrors its internal value. The rupee is not overvalued against other currencies but it is overvalued relative to India’s poor economic fundamentals. Changing the mirror will not alter the reality. It may even worsen it.

[1] See http://niti.gov.in/writereaddata/files/document_publication/EoDB_Report.pdf (accessed on 3rd October 2017)