The dangers of an overvalued rupee

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An export-led growth strategy with appropriate structural reforms, comprising liberalisation and an open economy, results in sustained productivity-led growth, as exports promote better resource allocation, efficient management, economies of scale and technology spillovers. Examples are the Asian Tigers, including China, which followed an export-led growth strategy and increased their participation in global value chains (GVC), expanding their tradable and manufacturing sectors as well as creating jobs and boosting growth.

One of the reasons, among other structural reforms, for the success of China’s export-led growth was an under-valued exchange rate that helped the country increase its share in world exports from one per cent in 1980 to around 14 per cent in 2016-17. In contrast, the appreciation of the rupee over the last few quarters may have hurt the competitiveness of Indian exports in world markets.

India’s trade-based exchange rates with base year 2004-05 — both the real effective exchange rate (REER) and nominal effective exchange rate (NEER) — reveal the rupee’s appreciation since May 2016. In fact, REER value has been above 100 for many years, indicating that the rupee is overvalued and the exchange rate is far from the equilibrium level. The 36-country-based REER index, which matters to export competitiveness, increased from 105 in 2013-14 to 116 in 2016-17, increasing by more than 10 per cent. Though growth in the REER and NEER indices has decelerated in recent months, the upward trend reflects the appreciation of the rupee.

The trade-based, six-country REER has also been high and rose to around 133 by mid-2017, from 120 in March 2016. Comparing the inter-temporal real exchange rate across countries shows that while most exporters — such as China, Japan, UK, Korea, Brazil and Philippines — have experienced a fall in real exchange rate since 2013, and more so by mid-2017, India is the only country to have experienced a consistent improvement in REER over the past few years.

A tight monetary policy along with the positive outlook of the Indian economy has resulted in huge capital inflows, mostly short-term in nature, which have played a major role in strengthening the rupee. Since mid-2016, there has been a gradual upsurge in the indices of exchange rates and the highest growth of around eight per cent was observed in April 2017, which could be due to the BJP's victory in UP, which created positive expectations for big ticket reforms and growth.

Further, currency appreciation in the last few quarters is largely a result of relaxation in the capital account and lack of aggressive intervention by the RBI in sterilising foreign capital inflows. The RBI’s lack of interest in intervening in the market, the government’s indirect support for a strong currency and positive growth prospects among major economies created expectations that the rupee would appreciate. This encouraged capital inflows, particularly into the equity market, as any rupee appreciation would also result in a proportionate increase in return on investment.

A REER of more than 100 and rising reflects the exchange rate mis-alignment that is affecting India's exports and that has the potential to create volatility in the external sector of the economy. One lesson from the East Asian crisis is that a persistently overvalued exchange rate leads to a crisis. In contrast, a well-managed, undervalued currency with appropriate reforms could be hugely beneficial, as China’s example shows.

REER appreciation is not good for Indian industry, since it reduces the competitiveness of exports and the tradable sectors — especially now, in a situation of overcapacity. However, the high fiscal deficit and high ratio of debt to GDP gives the RBI little space to allow the rupee to depreciate by intervening in the forex market, as this would lead to higher inflation through exchange rate pass-through. Inflation is a politically sensitive subject and, moreover, RBI uses the exchange rate mechanism to achieve its inflation targeting mandate. As per the monetary policy report released in April, a five per cent appreciation of the rupee reduces headline inflation by 10-15 points, and therefore the stronger rupee has been used to control inflation. India’s top imports include oil, precious metals, electronics and machinery, among others, and the rising rupee makes these imports cheaper.

The strengthening rupee hurts exporters’ competitiveness and earnings. Many industries — gems and jewellery, textiles, leather and agricultural products — are labour-intensive and export-dependent. The supply chain of export industries involves millions of SMEs. Therefore, a rising rupee is not good for employment as well. Even the services sector is affected negatively, particularly for those whose export earnings are foreign currency-dominated. For example, software export — where India has dominated the world market so far — is experiencing lower profit margins and intense global competition does not allow the industry to raise prices to maintain profit margins. In recent years, prominent industries such as software, pharmaceuticals and automobiles, whose earnings are significantly dollar-denominated, have been experiencing lower earnings.

Though a rising rupee is not a bad thing, as it has helped contain inflation through cheap imports as well as companies that have foreign currency-denominated debt, the strategy may not be right to sustain growth in the long run. Cheap imports do help contain inflation in the short term, but affect domestic production and jobs, particularly in manufacturing, in the medium and long term. India’s CPI inflation is based more on a non-tradable basket and influenced by supply-side bottlenecks. Therefore, allowing the rupee to depreciate may not affect inflation much due to pass-through, provided the economy pursues structural reforms across sectors to improve productivity-led growth.

It is time to correct the mis-alignment in the exchange rate and allow the rupee to move towards its true value, as it is hurting Indian exports, investment and SMEs associated with export sectors that create jobs. The rupee is overvalued by 10-15 per cent and should be allowed to depreciate. The Indian economy needs to be efficient, and it needs to grow and create jobs. An overvalued currency is also susceptible to volatility; there could be a run on the rupee due to sudden capital outflows, given the higher fiscal and current account deficits.

The writer is Professor, Institute of Economic Growth, Delhi University


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