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Sajjid Chinoy: The rupee and the J curve

The rupee depreciation has underpinned a meaningful improvement in the trade deficit. Can the economy take advantage of this?

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There has been little to cheer about on the macro front for months. Last week’s negative industrial production, or IP, print was the latest reminder that industry has ground to a halt and growth seems reconciled to the five to six per cent range. Unlike China, however, slowing growth has not resulted in slowing inflation. Wholesale inflation remains stubbornly above seven per cent and retail inflation is in double digits. The economy seems stuck in a low-growth, high-inflation equilibrium – reminiscent of the late 1990s – such that the Reserve Bank of India’s hands are tied even as growth continues to flounder.

As if this is not bad enough, the developing drought-like situation will accentuate these perverse growth-inflation dynamics. Moreover, it will also severely constrain the other arm of policy-making — the fisc. A drought will trigger automatic fiscal stabilisers (National Rural Employment Guarantee Act and drought-relief packages), make it politically harder to rein in subsidies and impede the much-needed fiscal consolidation.

In the light of this macro gloom and doom, it was not surprising that markets cheered wildly when the compressed sharply in June. The sharp deterioration of the last year along with the fiscal slippage (the infamous “twin deficits” of India) had soured sentiment and pressured the currency. In the light of this, when the trade deficit plummeted to $10 billion in June from $16 billion in May, there was rejoicing all around with the rupee appreciating almost two per cent upon the news.

But markets should not have been surprised. The sharp real depreciation of the Indian rupee – more than 12 per cent over the last year – was bound to compress India’s trade and current account deficit by making exports more competitive and imports more expensive, thereby disincentivising the latter vis-à-vis their domestic substitutes.

This is a well-documented phenomenon in economics known as the “J curve”. Measured in domestic currency, the trade deficit should first deteriorate upon a currency depreciation as the price effect filters through immediately. Over time, export volumes should rise, import volumes fall and the trade balance improve — hence the J.

So, is India in the midst of a J curve? And when did it start? Before answering those questions, however, the market’s surprise at the compression of the trade deficit reveals a broader scepticism about the impact of the currency on key macro variables – the current account, growth and inflation – in modern-day India. The depreciation of the currency over the last year has been one of the most important – and needed – price adjustments that has taken place, but one that is not recognised.

Exports and imports now comprise almost 60 per cent of — as opposed to just 25 per cent a decade ago. So, a nominal depreciation of more than 20 per cent and a real depreciation of 12 per cent in a year is bound to have an impact on inflation activity, the balance of payments and the domestic attractiveness of the tradables vis-à-vis the non-tradable sector — contrary to the scepticism of some.

So, are we seeing a J curve in India? Absolutely. And not just reflected in the June numbers. Instead, this phenomenon started a while ago. The seasonally-adjusted, monthly trade deficit was averaging almost $19 billion at the beginning of the year (on a three-month-moving average basis), but narrowed to $15 billion by May and $11 billion by June.

But isn’t this just oil and gold imports coming off in recent months? This is the natural first reaction of most. The implication being that as oil prices tick back up, the trade deficit will balloon again.

Unfortunately, the perception is very different from the reality. Even as the quarterly trade deficit compressed sharply between the 4Q 2011 and 2Q 2012, net oil imports actually rose during that period. Gold imports, undoubtedly, decreased but the decrease was less than half the compression of the trade deficit.

So, what’s driving the decline? It’s the non-oil and non-gold deficit that has improved dramatically over the past six months (by $7 billion a quarter), impacted undoubtedly by the sharp currency depreciation.

The logical next question, therefore, is whether this has happened through export buoyancy or import compression? It’s unambiguously the latter. Non-oil exports haven’t shown much buoyancy but that is not surprising because the currency depreciation has occurred in the middle of a fragile and slowing global economy. With India’s engineering and pharmaceutical exports being far more sensitive to partner-country growth than the exchange rate, the lack of an export pick-up has not been surprising.

Instead, the improvement has occurred largely through import compression. Non-oil and non-gold imports have contracted almost 13 per cent over the last two quarters, in response to the depreciation of the currency. Whoever said exchange rates don’t matter in India!

Nowhere is this seen better than in the bilateral trade deficit between Indian and China. Indian producers have long complained about “cheap Chinese imports”. In theory, therefore, Chinese imports should have reduced as the 12 per cent real depreciation renders Chinese imports less competitive. That’s exactly what we find. India’s bilateral trade deficit with has compressed 30 per cent over the past nine months as imports from China have contracted 13 per cent over the last three quarters and exports to China have picked up.

So that, in a nutshell, is the story of India’s J curve: a sharp compression of the trade deficit driven primarily by non-oil and non-gold imports on account of the sharp real depreciation of the currency.

But while the exchange rate has had the desired impact on the current account, why hasn’t this boosted domestic activity, as consumers and producers switch from imports to domestic substitutes? And why hasn’t the narrowing current account deficit put pressure on the rupee to appreciate? The answer to both questions, unfortunately, comes down to the real sector and policy frailties at home.

To be fair, given the differentiated nature of goods trade, any switch to domestic substitutes will take time. So, it is premature to pass judgment too soon. But anecdotal evidence suggests that binding capacity constraints in key sectors – in response to sluggish investment for several quarters – is a key reason domestic production has not ramped up sharply in response to the import compression thus far.

And why does the rupee continue to languish despite a narrowing trade deficit? The answer is more straightforward. Capital flows have fallen in tandem over the past few months partly reflecting worsening global conditions but mainly reflecting India-specific concerns. So, while the current account has compressed, so has the capital account.

With important personnel changes in the finance ministry in recent weeks, expectations have risen that the government will finally bite the bullet on a host of long-awaited policy measures. If policy makers can deliver, capital flows will likely get a boost that, in conjunction with the narrowing current account deficit, could drive a meaningful appreciation of the rupee.

If not, the rupee is expected to languish and possibly even weaken further. And we would have wasted the J curve.

The writer is India Economist for JP Morgan

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