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.