Beware a strong rupee

Long periods of a ‘strong’ currency has not been good for growth and development of nations

Four years ago when the India’s external finances were going through a mini-crisis and the ~/$ rate was close to 70 no one would have predicted that today it would be around 64. Even as recently as January this year, the ~/$ rate averaged 68 for the month. Nor is this strengthening of the rupee limited to the rupee-dollar parity. The Reserve Bank of India’s 36-country, trade-weighted (2004-05 base) Real Effective Exchange Rate (REER) index, which takes into account exchange rate movements with respect to 36 trading partners/competitors and adjusts for inflation differentials, also shows a pattern of strengthening from 103 in 201314 to 112 in 2015-16 and further to 118 in March 2017. What’s going on?

In some government quarters there is considerable satisfaction about this strengthening of the rupee in recent years and months. It is attributed to “strong fundamentals” of good growth, low inflation, fiscal consolidation and low current account deficits (CADs) in the balance of payments (well below 2 per cent of gross domestic product [GDP]) for four years in a row. While there may be some merit in this point of view, it should not distract policymakers from other pertinent factors and perspectives.

First, as noted, some of this rupee strengthening is quite recent, in the last three or four months. It appears to be due to a number of factors, including a reversal in the initial, Donald Trump electionrelated strengthening of the dollar, a recent downward correction in oil and other commodity prices and the return of foreign portfolio inflows into India after their withdrawal in the initial weeks following the November 2016 demonetisation. The point is short-run factors such as these may or may not persist in the medium-term. From a policy-perspective it is crucially important to take a medium-term view of the exchange rate policy based on a good understanding of past trends and factors (and their consequences) and reasonable judgements about possible future trajectories.

Second, the history of global economic development since 1950 does not support the view that long periods of a “strong” currency have been good for growth and development of nations. On the contrary, the best practitioners of sustained rapid growth, mostly East Asian economies such as Japan, South Korea, Taiwan, China and Thailand, generally eschewed currency “strength” and opted to maintain competitive exchange rates to help gain market share in global trade. In India too, periods of good growth in exports and trade were generally associated with periods of realistic exchange rate policies. This is hardly surprising, since theory indicates that a currency depreciation is equivalent to the imposition of a tariff on imports of goods and services and a subsidy to exports, while a currency appreciation “subsidises” imports and taxes exports.

Of course, the trade performance of a country is not solely dependent on currency policies. Many other factors come into play, including global economic conditions, fiscal policy, infrastructure (quality and quantity), foreign trade policies, investment climate, skill development, and ease of doing business, to mention a few. But surely, currency policy is an important determinant. Nor are the consequences of currency policy limited to trade performance. An overvalued currency can be a strong disincentive to the development of “tradeable” sectors, notably industry and agriculture. This is of vital importance to India, where rapid growth of these sectors offers the best hope for generating decent job opportunities to a growing, low-skilled and underemployed labour force.

Third, let us briefly review our external sector experience over the past decade to see what guidance we can glean (see table). A striking feature of the past decade has been high levels of merchandise trade deficit recorded, ranging between 6 to 11 per cent of GDP and averaging above 8 per cent. We have been able to sustain this because of the high levels of “Net Invisibles” earnings, constituted mainly by software exports and remittances from abroad, which, together, have averaged around 6 per cent of GDP per year. Much of the decade, certainly between from 2005-2013, overlapped with the China-fuelled commodity “super-cycle”, which kept oil and other commodity prices high. As a substantial net importer of petroleum products, significant strain on our external finances was inevitable. But in the years leading up to the 2013 “mini-crisis”, the REER was also allowed to appreciate from 100 in 2008-09 to above 110 in 2010-12. This may well have compounded the oil-price strain, since the non-oil trade deficit also rose to a peak of nearly 5 per cent of GDP in 2011-12 and 2012-13, contributing to the record CADs of above 4 per cent of GDP in those years.

These unprecedented CADs were brought under control in 2013-14 through strong measures to curb gold imports. In the years since then we were blessed, fortuitously, by the collapse in oil and other commodity prices, which (mainly) reduced merchandise imports from a peak of over 27 per cent of GDP in 2012-13 to 19 per cent in 2015-16. But for this large terms of trade windfall, our external finances might have been far less comfortable. Certainly, there was no positive adjustment through exports, which remained stagnant in value, and dropping, as a share of GDP, from 17 per cent in 2013-14 to less than 13 per cent in 2015-16. Even non-oil exports declined from 13.5 per cent of GDP to 11.2 per cent over the two years, partly because our policy authorities (government and the RBI) allowed the REER to climb back up to 110 and higher.

Looking ahead, if oil prices remain around $50/barrel or lower, and our authorities continue to encourage a “strong” rupee, then external finances will deteriorate only gradually, as goods exports, software exports and remittances (the three big forex earners) all decline slowly, as shares of GDP. Greater damage would be inflicted on the dynamism of the “tradeable sectors”, and hence, on job creation by them. Of course, if oil and other commodity prices perk up in the near term, then trade and CADs will widen quicker and the rupee will weaken more swiftly. That may not be such a bad outcome!