Wednesday, 10 July 2013

Losing currency

Indian Express, 10th July 2013

To shore up rupee, policy must boost domestic productivity, assure foreign investors

The sharp decline in the value of the rupee in recent days has led to a clamour for the government to do something. But there are few easy options available. RBI intervention is likely to have limited impact in the face of the huge pressure on the rupee caused by global capital movements. Domestic interest rates cannot be raised to attract foreign inflows because of the decline in growth and investment in the country. Reducing imports though imposing restrictions on gold has had limited effect. The falling rupee is a consequence of global developments as well as a sign of longer-term features of the Indian economy. Addressing the symptoms, that is, the rupee fall, could give us short-term relief, but soon the same problems will surface again.

First, let us place the rupee decline in perspective. When we compare the slide of the rupee to the behaviour of other currencies in June, when the rupee depreciated sharply, it appears as if other emerging economy currencies depreciated less, while the rupee fell sharply. However, when we compare the rupee-dollar rate to other large emerging market (EM) economy currencies, like those of Brazil, South Africa, Korea or Turkey over a longer period, starting in January 2013, we find that most of those currencies had depreciated earlier, particularly between mid-February and mid-March, while the rupee had held up. The US dollar trade weighted index shows similar trends. As a consequence, what appears to be a very sharp depreciation compared to other large EM currencies is not such a sharp depreciation. Indeed, if the rupee had not depreciated, it would have lost competitiveness against other currencies. With high inflation continuing to plague the Indian economy, the recent depreciation has prevented the real exchange rate of the rupee from becoming overvalued. As long as inflation in India is higher, in the long run we are likely to get a nominal depreciation that would prevent real exchange rate appreciation. So if our cost of production is growing at 10 per cent while, say, for the sake of argument, the others are at zero, then after five years, do not expect that the rupee will remain at 60. It should be expected to depreciate. By how much will depend on capital flows to and from India. For instance, earlier in the year, foreign capital continued to flow into India and the rupee did not fall.

The short-run approach to reducing the pressure on the rupee has been to curb imports of gold to lower the current account deficit. Recent evidence suggests two trends. First, official imports of gold have declined. Second, gold smuggling has increased. Government policies to reduce gold imports are aimed at official imports. It is not clear why the government believes that a shift from official channels to smuggling will solve the question of the inflow of gold or its impact on the rupee. It might have the naive faith that total gold imports will go down if restrictions are imposed, and the criminality it introduces into the system is a worthwhile price to pay for reducing the pressure on the rupee. But gold imports are a means of capital flight. If households do not have attractive assets to invest in, if real interest rates on bank deposits are low, if the real estate market is full of black money and scams, gold appears to be an attractive asset for households. Restrictions on gold have not made the rupee stronger.

Ultimately, a currency gets stronger if the economy witnesses higher productivity growth than the rest of the world. During the months that we have been worried about the rupee depreciating, the Chinese yuan has been appreciating. In addition, domestic inflation in China is high and wages are rising. This offers India an opportunity to step in when China inevitably loses its share of foreign markets. But for this, India needs to remove hurdles to the growth of large-scale industry in toys, textiles, engineering goods, household appliances and various consumer durables. This will involve changes in the exit policy of industry, labour laws, policies on foreign direct investment, removal of the infinite obstacles to investment, improving infrastructure such as power, fuel, raw material supply, ports and airports. Addressing these can give us higher productivity growth, which in turn would give us a strong rupee. But these are difficult problems to fix. India has barely begun to understand the problems we face in these sectors. We are far from fixing them. In all probability, we will helplessly watch Bangladesh, Pakistan and Vietnam step into China's shoes.

Today, India can achieve very little export growth through export subsidies or by directly pushing exports, even if the WTO rules allowed that. Most of the problems that stop domestic producers from becoming more productive and export to the world market are policy and infrastructural issues. Until now, our approach has been to boost exports by making policies to help "exporters". That approach needs to change towards policies that lead to an increase in domestic productivity. It is when firms become more productive that they start serving foreign markets. The challenge today is to create an environment in which more firms become productive.

Another element of the reform India needs to undertake urgently is to clean up its foreign investment framework. Today, the framework is so messy that even the government finds it hard to enforce its own rules. The alphabet soup of FDI, FII, FPI, QFI and so forth has no clarity and the legal uncertainty in the system is so high that it manages to turn away even those investors who want to bring money into India.

The time for quick fixes is over. The RBI must be complimented on seeing the problems of trying to implement a peg to the USD back in 2007-08 and moving to a floating exchange rate. Had Subbarao not been wise enough to do that, India would have faced a balance of payments crisis in trying to defend the rupee.


  1. The permanent solution to stabilize the rupee would be sharp increase in exports and serious inflows in the form of FDI, RBI intervention is always been a short-term step to defend the rupee and beyond a point there is no scope for intervention as our deteriorating foreign exchange reserves shows a stop signal. Steps like not allowing banks to do prop. trading in F & O and meeting the dollar requirements of oil marketing and refining (PSU’S) companies from a single bank could curb the short term volatility.
    We have seen in the recent days government taking measures to tackle FDI problems. As mr.chidamabaram went to US in order to meet some FDI asipirants.some times I get surprised why these so much of measures are taken or required at a time, why these people talk about reforms when elections are ahead...why these measures were not taken over a period of time? At least issues related to industry problems, supply side bottlenecks (manufacturing) and measures to boost the exports could have taken over a period of time.
    Government is doing things when there is urgency (its like a last ball of the match and we require four or six to survive.This situation happened because we wasted initial and middle handling the corruption issues).

  2. "If households do not have attractive assets to invest in, if real interest rates on bank deposits are low, if the real estate market is full of black money and scams, gold appears to be an attractive asset for households."

    On your above statement could you explain how does an economy benefit by investing its resources in an unproductive asset such as gold?

    Investment in gold has always been seen as a hedge towards inflation. But in case of India higher investment in gold leads to a higher CAD, which results in a depreciated currency which fuels inflation (Since India is highly dependent on crude imports, a depreciated currency would cause inflation). So if I am not wrong, instead of acting as a hedge towards inflation, gold is the cause of inflation. Please post your views on this.

  3. Vishal, I think the problem is more to do with the political economy of growth and development in India than to do with economic theory itself: The UPA(1 and 2) has always treated growth as a "given" and decided to reap the benefits of the same by expanding the government balance sheet rapidly. That assuming growth was a given does not augur well for the economy was pointed out by many people. But then, nobody worries about it in good times. When we start worrying about sustaining growth, that is when true and meaningful engagement with an open economy and globalization is possible.

    Anonymous, if I may take the liberty of pointing you to three links that may provide some background to why a useless unproductive asset has so much importance. This is not only in India, but happens during times of stress all over the world. This takes one back to the question of what makes an asset what it is - it's just a collective view of valuation that is contained the price of the asset. That it is a "safe" asset may be a fallacy, but it exists as a back-up isn't fallacious at all.

    Regarding gold causing inflation: To a household, there are nominal return biases that are likely to corrode their view about this. It is an interesting thought, and perhaps there isn't much to suggest that gold is a hedge against inflation: It is just a store of value. Again, something that is my opinion but the jury is still out.