Why a weak rupee is welcome
The rupee has been declining against the U.S. dollar and reached its lowest level last month-end. At 68.85 to the dollar reached on November 23, this exchange rate is even lower than the sharp fall in 2013. Breathless TV headlines would describe this as “rupee plunges to its lowest level”, even though the actual movement could have been only a few paise down from the previous day. Back in 1991, when India undertook a sharp devaluation of the exchange rate, the rupee went from around 15 to 30 almost overnight. Ever since then, since the exchange rate was completely deregulated, the rupee has moved steadily down. Naturally every time it breaches the previous low mark, it has plunged to new depths. So while this may tempt some screaming headlines, that per se is not very insightful.
During the four years preceding 2014, average inflation was above 10 percent per annum. Which means what cost 100 rupees in the beginning of the year, cost 110 by the end of the year. Naturally, if the rupee loses purchasing power steadily internally in the country, its external value should also erode commensurately.
There is a very simple reason why the rupee is steadily declining against the US dollar in the last two and a half decades. The internal purchasing power of the rupee is eroded due to annual inflation. During the four years preceding 2014, average inflation was above 10 percent per annum. Which means what cost 100 rupees in the beginning of the year, cost 110 by the end of the year. Naturally, if the rupee loses purchasing power steadily internally in the country, its external value should also erode commensurately. Only if the inflation in the foreign country is even higher than India can the rupee in relative strengthen against that currency. And much of the developed world is suffering not from inflation, but deflation.
The Europeans and Japanese are desperately printing money so as to inject some positive inflation. In the U.S, too, the inflation rate is far less than two per cent, their supposed target rate. Inflation in India is currently running at above 5 percent, and that’s the main reason why the rupee declines against the dollar.
There are additional factors at play, apart from the inflation differential between India and US. These are the ebbs and flows of dollars moving in and out due to capital and current account transactions. Since India’s exports have not been doing well, dollar inflow on that account has suffered. But dollar inflow has been strong on the capital account, since India attracted record flows as FDI (the latest being the Russian funds into Essar Oil). However, since November 8, the flow has reversed.
It is now almost certain that the US Federal Reserve will start raising interest rates, starting as early as December. This means dollars will flow back to US, since return on US bonds are rising. Instead of earning near zero returns, as was the case, the US treasury bonds yields (i.e. returns) may head to 2 or 3 per cent.
The causative factors are both the abrupt large-scale demonetisation, and the unexpected victory of Donald Trump in the US. The removal of 86 percent of currency in circulation has been like a negative monetary shock, a sort of temporary contraction. It is expected to cause a dip in GDP growth in this and the next quarter, mainly due to a hit on consumer spending and the informal economy. No doubt next year the economy might see a rapid bounce back, but the stock and bond market foreign investors have chosen to exit for the time being. The exodus has also been reinforced by Trump’s victory. It is now almost certain that the US Federal Reserve will start raising interest rates, starting as early as December. This means dollars will flow back to US, since return on US bonds are rising. Instead of earning near zero returns, as was the case, the US treasury bonds yields (i.e. returns) may head to 2 or 3 per cent.
President Trump is also expected to give a special tax relief to companies who bring back their global profits, currently parked outside for tax reasons. This too is causing capital to flow back to US. Trump also promises to spend on infrastructure, possibly causing the fiscal deficit to expand, which again means higher interest rates on US bonds. Hence, for all these factors, in November (the cumulative effect of demonetisation and the unexpected victory of Trump) more than 2.7 billion dollars have exited in both the bond and stock markets (over 18,000 crores) worth dollars exited India. That is the reason that the exchange rate fell to a low of 68.85.
Next year promises to be one of global dollar strength, so that most currencies around the world will decline against the US dollar. Indeed, this month, while the rupee has fallen by 2.5 per cent, the Malaysian currency is down 5.6 per cent and Indonesian by 3.2 per cent. Even the Chinese currency will weaken.
However, the rupee fall may not be such a bad thing. The current situation is vastly different from May 2013, when there was all-round panic and mayhem. The rupee fell from around 54 to 69 in a very short time, triggering emergency and panic-type reactions. The Reserve Bank of India raised interest rates sharply, import duty on gold was hiked steeply, and outbound remittances were severely curtailed. As it is the current account deficit (CAD) was at a record 4.8% of GDP, adding to the worries, and sentiment on India had turned negative.
If Indian quality is as good as Chinese, then a stronger rupee tilts the advantage toward the latter. In an open economy regime, banning imports is not an option, and is not even wise macroeconomic policy.
By contrast, in current times, the CAD is near zero, sentiment about India is extremely bullish and inflation is moderating. The rupee indeed needs to soften, because measured in real effective terms, i.e. adjusting for inflation differentials, and by taking a trade weighted average, the rupee has been highly overvalued. This is called the overvalued REER (real effective exchange rate) of the rupee. This affects our exports negatively. It also affects domestic industry, as with a strong rupee, the cheaper imports from countries like China flood domestic markets. It is not as if the exchange rate is a substitute for competitiveness, but at the margin it does matter. If Indian quality is as good as Chinese, then a stronger rupee tilts the advantage toward the latter. In an open economy regime, banning imports is not an option, and is not even wise macroeconomic policy.
So a weaker rupee, sliding moderately by around three or four per cent over the year may be a welcome development. It will help domestic industry (including exporters). With oil prices still remaining moderate, a weaker rupee will not add significantly to the import bill. It is also unlikely to contribute much to inflation. Indeed, by a reduction in its REER overvaluation, it will get closer to a fairer value.
This is an illustration of the case where a strong economy is not synonymous with a strong currency.
(The writer is a senior economist based in Mumbai)