The other day I addressed a conference arranged by a chamber of commerce in Mumbai. The theme of several presentations was the exchange rate.
And practically all the speakers expressed great satisfaction and pride in the strengthening of the rupee -- that the Indian economy can now command respect of the world, the rupee needs to be strong in order to become a global currency, the entire fall of the rupee in the 1990s can be reversed and so on.
The media too has expressed similar sentiments.
I find myself in a small minority that is concerned about the rise of the rupee and the impact it could have on the economy.
Somewhat surprisingly (at least to me), even my good friend Swaminathan Aiyar has now joined the chorus of analysts and economists, far more concerned about the cost of the rising reserves than the effects of the rising rupee, which is no longer a reflection of the dollar's weakness internationally.
In just about four months, the rupee has appreciated 3.25 per cent against the dollar and 4.6 per cent against the euro. In other words, the rupee's rise in recent months is independent of the dollar's weakness.
I recall an article I wrote in 1979 or 1980 related to the then exchange rate policy. Those were the days when the rupee was linked to a secret basket of currencies. Using regression analysis, I had concluded that the basket seemed to be $1 + £ 0.5 = Rs 30 (if memory serves me right).
At that time, both these currencies were appreciating in the international markets and I had criticised the linkage to the two strongest currencies when our inflation was also much higher.
Not that what I wrote had any impact -- in any case, nowhere near the impact Y V Reddy's statement about the real effective appreciation of the rupee in August 1997.
It was one of the rare instances where oral intervention by the central bank worked and the rupee fell. Reddy may need to repeat the performance in his new avatar as the Reserve Bank of India governor.
The arguments of those who believe that the RBI should stop buying dollars, that is, accumulating reserves, fall in two parts:
- The deliberate undervaluation of the rupee is leading to "a mercantilist maximisation of exports"; and
- Reserves accumulation entails costs that outweigh the benefits of a lower rupee. The costs are both opportunity costs in terms of the resources "blocked" in reserves accumulation as also in the interest costs of maintaining the reserves.
Let us first look at whether there is much substance to the argument that the rupee is being kept deliberately undervalued for "a mercantilist maximisation of exports".
To my mind, there would be two ways of looking at the issue.
The first one, of course, is in terms of the real effective exchange rate (REER index base 1993-94). My estimate of the current level of the index is of the order of 101, if not higher -- evidencing an appreciation of the rupee in REER terms.
To be sure, looking at only the REER Index ignores other important areas where India seems to have gained in competitiveness -- areas like export transaction costs (one EXIM bank study shows a sharp fall in such costs) and productivity improvements in terms of both capital and labour in much of the manufacturing sector.
To be sure, there are no reliable macro-level data on the productivity improvements, but there is enough micro-level evidence to accept the proposition.
It could be argued therefore that in these circumstances the rise of the REER exaggerates the fall in competitiveness in the Indian economy, more so as most of our competitors have achieved such productivity gains much before us.
Those who use this argument could also point to the continued rise in exports, at least in dollar terms, as evidence of the competitiveness of the current REER.
But this argument is not fully convincing. First, while exports have grown, even in August, in dollar terms, they have started falling in rupee terms.
Again, the growth even in dollar terms has sharply decelerated and, inasmuch as exchange rate changes affect growth of exports with a lag of anywhere from six months to a year, the deceleration in growth could well turn into an actual fall even in dollar terms in the coming months.
Second, models and theoretical arguments apart, the proof of the pudding, as they say, is in the eating.
And the reality is that, even when all the slated duty cuts are yet to be implemented, we continue to sustain significant deficits on the trade account -- and this is hardly evidence of the currency's alleged undervaluation.
More on this in next time.
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