A V Rajwade: Currency questions
It is hard to understand why two different approaches are used to determine the external and the domestic values of the rupee
It is hard to understand why two different approaches are used to determine the external and domestic values of the rupee.
The recent debate in the media on inflation and monetary policy has provoked one thought: those who articulate maximum concern for bringing down inflation by monetary tightening – many of whom are from the financial sector – because the “poor” are supposed to suffer most from it, generally favour free flow of cross-border capital and its corollary, market-determined exchange rates. Obviously, they are little concerned about growth and jobs lost, or not created, because of currency appreciation and the resultant external deficit. (Economics 101 teaches us that net exports are a component of GDP.) One wonders whether the concern about inflation is not equally reflecting the need to protect the real value of the savings of the rich, for whom volatile exchange rates provide an opportunity to make more money through speculation, often described as trading, hence the advocacy of market-determined exchange rates. Otherwise, it is difficult to understand why such a dramatically differing approach is advocated for the two values of the domestic currency – domestic value determined by inflation and the external value determined by the exchange rate – and that too in an increasingly globalised world economy.
As I said last week, even proponents of a liberal capital account and floating exchange rates have to admit that the exchange rate has an important influence on the competitiveness of the tradeables sector. Does the sharp increase in exports in the past four months suggest that they have not been affected by the significant real appreciation of the rupee? Frankly, I am puzzled since the phenomenon goes completely against the basic logic of competitiveness. I seem to be in good company. To quote from the RBI governor’s replies in the post-policy question-and-answer session, “We were also very pleasantly surprised by the increase in exports growth in last quarter of last year.” It has been claimed that the growth is the result of a diversification in the product mix and markets for our exports. But, as the governor said, “It is not very clear that hypothesis stands to empirical scrutiny because some initial research done in the Reserve Bank shows that the impact of that diversification is actually quite small. So there is something else that played there and we need to investigate that.” In fact, the export growth seems as miraculous as India’s overall economic growth when, in the World Bank’s “Ease of Doing Business” index, India ranks 134th out of 183 countries, scoring particularly badly on ease of starting a business (165th) and, above all, enforcing contracts (182nd, behind Angola but pipped by Timor-Leste for the bottom slot). Another index on “Entrepreneurship and Opportunity”, produced by the Legatum Institute, a think-tank, puts India 93rd out of 110 countries” (The Economist, April 20, 2011).
| DEFICIT DIARY ($mn) | |||
| Year | Trade deficit | Current account deficit | Current account deficit net of remittances |
| 2000-01 | -12,460 | -2,666 | -15,520 |
| 2001-02 | -11,574 | 3,400 | -11,998 |
| 2002-03 | -10,690 | 6,345 | -10,042 |
| 2003-04 | -13,718 | 14,083 | -7,525 |
| 2004-05 | -33,702 | -2,470 | -22,995 |
| 2005-06 | -51,904 | -9,902 | -34,395 |
| 2006-07 | -61,782 | -9,565 | -39,390 |
| 2007-08 | -91,626 | -17,034 | -58,739 |
| 2008-09 | -119,403 | -27,900 | -71,947 |
| 2009-10 | -118,400 | -38,411 | -90,466 |
| 2010-11 | -102,100 | -38,900 | -78,400 |
Exports apart, equally important is the competitiveness of the domestic economy with imports — in other words, trade and current account deficits. The table gives the trade and current account balances from 2000-01 to 2010-11 (first three quarters). Some conclusions are inescapable:
- The merchandise trade deficit was fairly small until 2003-04 but has gone up very sharply thereafter.
- The current account deficit, as conventionally calculated, was fairly modest until 2006-07, but has galloped since then. (In my view, the current account deficit, net of remittances, is a better reflection of the domestic economy’s competitiveness as, for economic analysis, remittances need to be treated more as capital transfers, though of an irreversible nature, a way of financing the deficits between external income and expenditure, not “earnings” of the domestic economy.)
- Through the period, the nominal exchange rate has remained relatively stable. In other words, there has been a very sharp appreciation of the rupee in real, that is, inflation-adjusted, terms.
Are these changes merely reflective of the savings investment imbalance or of a dramatic, unannounced change in the exchange rate policy? Are savings and investments exogenous to the exchange rate? More on this next week.