Automatic stabiliser

Rupee depreciation helping the business cycle bottom out

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In textbook macroeconomic models, a floating exchange rate is viewed as an automatic stabiliser. When the balance of payments of an economy is under stress because of a large current account deficit or a drop in capital inflows, the currency depreciates, causing exports to increase and imports to decline, thus easing the stress. In the other direction, when there is a surplus situation, the currency appreciates, causing the current account deficit to widen, which eases the pressure. Of course, textbook models are oversimplifications, but that does not make them either irrelevant or inaccurate. The behaviour of the rupee over the past two years has conformed quite closely to the predictions of such models. The larger the current account deficit has grown, the more intense the pressure to depreciate has been. Whenever there has been a trigger - in the most recent instance, the threat of a taper by the United States Federal Reserve - the decline has been sharp and swift. But, apart from the suddenness of it, this need not at all be bad news. Once the rupee stabilises, Indian exporters are significantly more competitive than a year ago, as are producers who compete against imported products in the domestic market.

Analysis of second-quarter corporate results by the Business Standard Research Bureau shows just how quickly these benefits may be materialising for Indian companies. Analysis of the companies comprising the Nifty index (excluding banking, financial services and oil marketing companies) indicates that both their aggregate revenues and profits grew by over 20 per cent year on year and both these indicators were also significantly higher than they were just a quarter ago. Since the dominant macroeconomic development during this period was the rupee depreciation, this clearly played a role in the performance, consistent with the automatic stabilisation perspective. With the rupee having stabilised and likely to remain that way for some time, the next couple of quarters at least are also likely to show the same patterns. Essentially, the angst about a depreciated rupee seems to have been overdone, at least in terms of its impact on corporate performance; importantly, this is not confined to exporting firms alone.

However, this is by no means an indication that the business cycle has turned or will do so in the near future. For one, many sectors are significant importers of various inputs, which, with a lower rupee value, will exert pressure on costs and, consequently, profitability. Also, many products and services are non-tradable, which means that their performance is dependent on domestic cost and demand conditions. Weak incentives to invest and the likelihood of expenditure constraints by the government do not offer much prospect of a domestic demand revival, while higher energy costs as a result of rupee depreciation will in any case put pressure on costs. The inflationary risks inherent in a lower rupee are also contributing to the focus of monetary policy shifting back towards containing inflation. All these factors suggest that the basic economic landscape is still somewhat bleak. It will take a significant policy push to restore the investment climate to its state during the mid-2000s, when investment activity boomed. Meanwhile, though, the adjustment in the rupee is doing exactly what the textbooks said it would: helping to bottom out the business cycle.