Why rupee loses more than currencies of nations with slower growth

A country's currency gets stronger as its productivity rises relative to others; India needs more labour-intensive activity to absorb surplus labour from agriculture, writes T N Ninan

Economic theory tells us that a country’s currency becomes more expensive (ie, it rises relative to other currencies) as its productivity level rises relative to others. The reason has to do with goods and services that can be traded internationally, like cars, as against those that can’t, like hair-cuts. As productivity (ie car output per employee) goes up at Maruti, the price of a hair-cut will go up by more than the price of a car — since a barber cannot improve his productivity (hair-cuts per year) in the way that a car company can through automation. This explains why hair-cuts cost more in higher-income (ie higher-productivity) countries like the US than they do in India.

 
Currencies move up and down also for reasons other than productivity — like relative inflation rates, resource inputs and an economy’s attractiveness to foreign capital. If inflation rates are high, or capital is flowing out instead of coming in, or if trade shows a large deficit, then that country’s currency will lose value. In general, therefore, a better-managed economy will see its currency gaining strength, while poorly-managed ones will see the opposite. Over the past decade, for instance, the worst-performing currencies have been those of crisis-ridden countries like Argentina, Turkey and Russia. Brazil hasn’t done too well either.
 

From that perspective, how well or badly has India been doing? In the Asian context, not very well. While the rupee’s value has seen little change over a decade, relative to the Sri Lankan or Pakistani rupee (and Pakistan is no one’s idea of a well-managed economy), it has lost value against all other major Asian currencies, including that of Bangladesh and of course China. A decade ago, a Bangladeshi taka fetched only 69 Indian paise, now it fetches 86 paise. Whether it is the Philippine peso, the Malaysian ringgit or the Thai baht, or for that matter the Vietnamese dong, the rupee has lost relative value to varying degrees since 2008. The rupee’s relative decline would have been smaller if the comparisons had been made before the rupee’s recent fall, but decline would have registered even then.

 

The scope for gains in productivity is greater in an emerging market than in a developed economy (because of the possibility of catch-up), so a well-ordered emerging market should see its currency gaining not just against other emerging economies but also against those of the developed economies. And so it is that the Thai baht has gained significantly against both the dollar and the euro over the past decade, while the Chinese yuan has kept pace with a strong dollar. The ringgit has kept pace with the euro, while the Philippine peso has gained ground against Europe’s currency. In clear contrast, the rupee has lost significant ground against both the world’s major currencies.

 
Why should this be the case when the Indian economy has been growing faster than these economies, other than China? One explanation could be that most “tradeables” (manufacturing and agriculture) have not been doing quite so well. Another is that economic growth flows from several factors, including population growth, and does not necessarily imply “factor” productivity growth as well. Thus, close to half the Indian workforce is still engaged in the least productive of virtually all activities, farming — where incomes in India are only a sixth of the incomes in non-farming activities. Further, much of India’s exports continue to be from sectors where low labour costs are a major competitive advantage — as in diamond cutting and garments. In comparison, China has moved from toys and garments to higher-value-added activities like making robots and specialty materials.

 
It goes without saying that what India needs at its present stage of development is more labour-intensive activity outside of agriculture, so as to absorb surplus labour from agriculture. Almost any movement of labour from it to non-agricultural activity (like the construction trades, or serving tourists) will translate into productivity gain. The test of whether such transitions are taking place fast enough will show in what happens to the rupee over the next few years.