COMMENTARY

july 20, 2013 vol xlviii no 29 EPW Economic & Political Weekly
20
External Sector, Growth
and the Exchange Rate
A V Rajwade
India has to acknowledge that it
needs to manage the exchange
rate rather than claim it should be
market-determined. The rupee
remains overvalued. To avoid a
balance-of-payments crisis caused
by the large current account
decit what is needed is
depreciation of the rupee to
somewhere around Rs 70+ level
and the adoption of tight,
deationary monetary and scal
policies which would be
extremely bitter.
1 Background
O
ver the month of June, as foreign
institutional investors repatriated
$7 billion (bn) of investments
from the debt and equity markets, the
rupee fell from 56.50 a dollar at the
b eginning of the month to a low of al-
most 60.75. At the time of writing (on 4
July), it was trading slightly above Rs 60.
This article discusses how vulnerable
I ndias external sector is and the pros-
pects for the exchange rate.
After the reforms of the early 1990s,
for a decade and a half, the Reserve Bank
of India (RBI) was actively engaged in
managing the external value of the rupee
through market intervention so as to
keep it reasonably stable in real, i e, ina-
tion adjusted, terms, even as the capital
account was liberalised. The resulting
impact on money supply was sterilised
through open market operations. (In the
process the RBI built up reserves of $300
bn, starting practically from scratch,
which helped India withstand the global
nancial crisis of 2008-09 without much
damage). The result of the policy was a
modest decit on the current account
there was indeed a small surplus in
2001-02, 2002-03 and 2003-04. As
recently as 2006-07, the decit was
b elow $ 10 bn or around 1% of gross
d omestic product (GDP). It has since in-
creased each year, to reach close to $90
bn by the end of 2012-13, or nearly 5% of
GDP. In the process, net external liabili-
ties have jumped from 40 bn (5.7% of
GDP) in 2004-05 to $300 bn (16.2% of
GDP) at the end of March 2013.
What changes in the economy or policy
have led to this dramatic deterioration?
In my view, the answer is clear: while
the public pronouncements about the
exchange rate policy have remained un-
changed that the RBI has no target in
mind, that it intervenes only to curb
external volatility, etc there is enough
empirical evidence to suggest the adop-
tion of a oating (or market-determined)
exchange rate over the last four to ve
years. The International Monetary Fund
(IMF) too describes the rupee as a oat-
ing currency. In fact, there seems to be a
strong correlation between a policy change
and the rapid increase in the current
account decit and net external liabilities
over the last several years. While corre-
lation is not always evidence of cause and
effect, basic economics suggests that the
exchange rate has a lot to do with the
comparative advantage or competitive-
ness of economies in the global market.
A V Rajwade (avrajwade@gmail.com) has been
a long-standing commentator on the external
sector and nancial services.
COMMENTARY
Economic & Political Weekly EPW july 20, 2013 vol xlviii no 29
21
As the current account decit has gone
on increasing, the policymakers focus
has been on how to nance it, rather than
on bringing it down. As for the latter, the
only step taken has been to increase the
import duty on gold, in stages, to 8%, to
curb imports. The efcacy of the step is
questionable: it may only encourage
smuggling and divert remittances from
the ofcial to the hawala channel, with
no benet to the current account. While
gold is an idle investment from an eco-
nomic perspective, inward remittances
(which the economy has not earned)
have more than nanced gold imports.
The oil import bill uctuates with
both the international price of oil and
domestic needs. What we often overlook
is that for much of the earlier decade and
a half of a managed exchange rate, India
registered a non-oil trade surplus. In
2012-13, the net oil import was $109 bn or
57.3% of the merchandise trade decit.
The emphasis on nancing, rather
than curtailing, the decit is also evident
in the recent Financial Stability Report
(June 2013) of the RBI. To quote from
paragraph 1.13
Non-disruptive nancing of the high CAD
and containing its size within sustainable
levels has become the key challenge in man-
aging the external sector and especially in
mitigating its vulnerability to global shocks.
In addition to the magnitude of ows needed
to nance the CAD, the composition of ows,
particularly dependence on portfolio and
short-term debt ows represent an added
source of concern.
Short-term debt (original and residual
maturity together) is now 44.1% of total
debt and equivalent to 59% of reserves.
In 2012-13, net foreign direct investment
(FDI) nanced only 22.5% of the current
account decit. The rest was through
volatile portfolio ows and external debt.
Thus, while the quantity of nancing of
the current account decit (CAD) was
a dequate in 2012-13, the quality has
d eteriorated signicantly.
2 The Real Exchange Rate
This analysis strongly suggests that the
root cause of the growing decit is that
the tradables sector of the Indian econo-
my is not globally competitive at the cur-
rent exchange rate. The interesting aspect
is that in its February 2013 report on
India, based on Article IV Consultations,
the IMF had argued that the real ex-
change rate is undervalued by 3.5-4.5%
if the current account gap is to be closed
only through real effective exchange
rate (REER) adjustment. What the IMF is
saying here is inexplicable. Raghuram
Rajan, the chief economic advisor, also
made the same point in his interview
(Mint, 14 June) arguing that, in terms of
the REER we are below the level which
we had when we were in 2004-05. So we
have come down perhaps more than
fundamentals would warrant. With due
respect I do not agree with either of the
observations, both of which seem to be
based on the REER index published by
the central bank. For one thing, the in-
dex as constructed is based on the cur-
rencies weights in the index represent-
ing bilateral merchandise trade with the
home country of the currency. This is
not a very good measure of the competi-
tiveness of the tradables sector as it
ignores competition from and in third
countries. (The RBIs REER index for May
was 92, suggesting an undervaluation of
the rupee by 8% compared to the base
year 2010-11!) The other weakness is
exclusion of trade in services which now
comes to 28% of merchandise trade.
And the frequent changes in the base
year do not help. Second, empirical evi-
dence in the form of growing merchan-
dise, even non-oil, trade and current ac-
count decits hardly supports the con-
clusion that the rupee is undervalued.
A better measure of the competitive-
ness may be the highly complex multi-
lateral exchange rate model developed
some years back by the IMF. A simpler
proxy to that is currency weights that re-
ect the proportion of our trade in goods
and services denominated in different
currencies. Given that as much as 80%
of Indias trade is in the US dollar, the
real rate against that currency is a far
better measure of the countrys competi-
tiveness than the RBIs bilateral trade
weighted model, an issue I had argued
in a 2011 arti cle (Business Standard,
3 January 2011).
But to come back to Raghuram Rajans
comment, he does seem to agree that the
real exchange rate matters. The calcula-
tions naturally depend on the starting
point and the ination measures used. I
have estimated the real rate changes
over the last 10 years using the US con-
sumer price index as a measure of Amer-
ican ination and Indias wholesale price
index (WPI) as a measure of domestic
ination, as the RBI itself does. (To be
sure, logically both measures need to be
identical.) This suggests a nominal rate
of Rs 70+. Interestingly, other inde-
pendent analysts estimates are not very
different. S S Tarapore in his recent
speech, Macroeconomic Perspectives in
Volatile Forex Markets, has estimated a
rate of Rs 70, based on an analysis of
the ination rates over the last two dec-
ades, and a starting point of Rs 31.37.
Two US academics (Business Standard,
7 May), using only four-year data, pre-
sumably the CPI in US and India, have
concluded that since early 2009, al-
though the accumulated price differen-
tial relative to the United States has
grown to about 35 per cent, the ex-
change rate has depreciated by only
around 10 per cent, creating an appreci-
ation of about 25 per cent. (In April, the
rate was around Rs 54.40 per dollar.)
The estimate of Nomura, the Japanese
investment bank, is not very different
an overvaluation of 17.6% when the rate
was around Rs 60. Can all these inde-
pendent estimates be grossly wrong
and the RBIs index evidencing an under-
valued rupee right?
3 Is the Present Rate Sustainable?
Subir Gokarn has argued in a recent
article (Business Standard, 17 May) that
there is a strong structural component
to the huge gap on trade and current
accounts. Unfortunately for students of
the subject, beyond claiming that Indian
exports need a boost from a new engine
(without specifying that engine),
Gokarn is silent on what exactly are
the structural, as distinct from macro-
economic policy, changes needed. Again,
he also seems to have ignored the com-
petition from imports to domestic manu-
facturers. Gokarn has also argued that
a small current account decit is not
an entitlement. The logical corollary
of the argument is that we are entitled
to live on imported capital forever.
This does not seem to be a very tenable
COMMENTARY
july 20, 2013 vol xlviii no 29 EPW Economic & Political Weekly
22
argument: only the US has the exorbi-
tant privilege of doing so since its cur-
rency is the principal reserve currency,
and surplus countries are forced to
nance its decits.
In fact, one has often wondered
whether our policymakers of recent years
believe that a managed exchange rate
is necessarily a manipulated exchange
rate, and hence to be esche wed; that
nancial markets are efcient produc-
ing prices which reect all fundamen-
tals and allocating capital where it will
yield the maximum output. Many econ-
omists have criticised the efcient mar-
kets hypothesis for a couple of decades,
one of them going to the extent of argu-
ing that it is the most remarkable error
in the history of economic theory (Rob-
ert Schiller). He made the argument
well before the nancial crisis of 2008
which itself is a strong refutation of mar-
ket efciency in allocating capital or
pricing risk.
In his A D Shroff Memorial Lecture
(November 2012) RBI Governor D Subba
Rao has argued that export competi-
tiveness...should come from improved
productivity rather than an articially
calibrated exchange rate. One is not clear
whether managing the exchange rate to
compensate for ination differential can
be described as articial calibration. The
other point is that nancial market prices
change far faster than productivity in-
creases and, in any case, in cross-border
comparisons of producti vity, the exchange
rate does come in the calculations.
But to come back to the issue of man-
aged/manipulated exchange rates, the
best distinction I have come across is in
a recent (July 2012) paper by Joseph
Gagnon of the Peterson Institute for
International Economics:
Currency manipulation occurs when a gov-
ernment buys or sells foreign currency to
push the exchange rate of its currency away
from its equilibrium value or to prevent the
exchange rate from moving toward its equi-
librium value. The equilibrium value of a
currency is that which is sustainable over
the long run. An exchange rate is sustain-
able if the current account balance is not
generating an explosive path for net foreign
assets relative to both domestic and foreign
wealth. Sustainability generally implies a
small value of the current account balance,
but fast-growing economies can maintain
moderate current account decits as long as
the associated liabilities do not grow faster
than their economic output.
As argued in above, neither condition
of sustainability is met in Indias case.
In short, whichever way one looks at
it (the real exchange rate or Gagnons
sustainability criteria) the present rate
does not seem sustainable.
Prospects for 2013-14
Some forecast a lower trade and CAD in
the current year: this is based on the
expectation that oil prices would remain
around $100 per barrel, and other com-
modity prices may also maintain a soften-
ing trend thanks to the slowdown in
China. As for the former, we should not
forget the volatile social/political situa-
tion in West Asia which has the potential
to dramatically change the expectation
about oil price. The other side, which
cannot be ignored, is that from a large
exporter of iron ore India could become
an importer in the current year thanks
to the closure of so many mines; that in-
creasing imports of coal will be needed
to fuel the power plants. As for gold, it is
often believed that the Indian psyches
hunger for gold arises from its attraction
as a safe hedge against ination and that
an ination indexed bond may therefore
reduce gold demand. To my mind, the
demand for gold has much more to do
with the cultural mores of the people
particularly the purchase of at least
some fresh gold for every marriage. As
long as this persists, with the increase in
the number of Indians coming to the
marriageable age, the demand for gold
may keep increasing. Perhaps, there may
be some possibility of a reduction in the
import of manufactured goods as the
domestic manufacturing sector becomes
more competitive at a depreciated ex-
change rate. But, overall, there is little
prospect of a signicant reduction in the
trade and current account decits in
scal 2013-14.
Whatever the advantage a depreciat-
ed rupee may give, it is well recognised
that there is a lag of a year or more be-
tween changes in the exchange rates
and its impact on trade. We should also
not overlook the fact that markets that
are once lost are difcult to regain. To
add to the problems, there seems to be a
denite slowdown in the growth of
services exports.
What all this suggests is that India
would need net capital inows of the or-
der of $100 bn in the current year just to
balance its books. The gross number will
have to be much larger thanks to the
large amount of maturing external debt.
And, this assumes that there would be
no outows by portfolio investors which
seem to have been the proximate cause
of the fall of the rupee in June.
Looking at the three principal seg-
ments of capital inows, the ideal situa-
tion would be if the bulk of the decit
could be nanced through FDI. While
some policy changes have been made,
the actual inow, for example in retail,
has been negligible. As for portfolio
ows, International investors have been
extraordinarily kind to India,.I dont
see how an economy growing at only
ve per cent with a currency that has de-
preciated by almost 35% since the end of
2007 can continue to interest equity
investors and attract ows of the magni-
tude needed (Akash Prakash, a Singa-
pore based fund manager, Business
Standard, 14 June). One could not agree
more. One wonders whether, in relation
to portfolio investments, India is in the
midst of a classic feedback loop: inves-
tors waiting for rate stability, which puts
further pressure on the rupee, which
delays inows.
Renancing of maturing debt may
well be constrained by the currency losses
already suffered by borrowers. The RBI
is clearly worried about the impact the
unhegded short positions of the corpo-
rate sector could have on the health of
the banking system. The fact is that in
the anxiety to nance the decit, the
External Commercial Borrowings (ECBs)
window has been opened to more and
more segments with no natural hedges
against rupee depreciation. Also, given
the huge imbalance between the poten-
tial supply in the forward market (ex-
ports) and the potential demand (im-
porters, borrowers and foreign institu-
tional investors (FIIs)) there is no way
that the domestic market would be
c apable of offering hedges for the bulk
of the short positions.
COMMENTARY
Economic & Political Weekly EPW july 20, 2013 vol xlviii no 29
23
Overall, it seems unrealistic to believe
that net capital inows on the needed
scale would materialise: the result could
well be that the rupee would remain
under downward pressure even in the
absence of outows of portfolio capital.
One should not rule out a balance-of-
payments crisis. To avoid/overcome it
what would be needed is to depreciate
the rupee to somewhere in the Rs 70+
level and adopt extremely tight, dea-
tionary monetary and scal policies to
get out of the cycle of high ination,
which would need a fall in the nominal
exchange rate, in turn, leading to fur-
ther ination. The medicine would be
bitter and it is most unlikely that a gov-
ernment facing elections in less than a
year would be able to administer it.
Growth and the Exchange Rate
There is no evidence that oating exchange
rates help growth. On the contrary, in
the modern era (last 70 years), every fast
growing economy from Germany and
Japan in the Bretton Woods era, to China
for the last 30 years have used xed/
managed exchange rates supporting
e xport-led manufacturing gro wth. If man-
aging the domestic value of a currency is
legitimate and important, surely manag-
ing the external value is no less crucial?
Remember, negative net exports corre-
spondingly reduce output, growth and
jobs, and their unchecked continuation
is a potential threat to nancial stability.