Given the real appreciation of the currencies of many emerging markets, commentators have been referring to the so-called Balassa-Samuelson hypothesis (1964): “An increase in the productivity of tradables relative to nontradables, if larger than in other countries, will cause an appreciation of the real exchange rate.” Recently, an article in Financial Times (February 28) referred to the hypothesis while suggesting that investors can gain from investing in emerging market currencies. One wonders, of course, to what extent the hypothesis is relevant in today’s world when capital account transactions rather than trade have become the single largest mover of the exchange rate, as in the case of India. In other words, it would be unrealistic to attribute the real appreciation of the rupee over the last couple of years to the increased productivity of India’s tradables sector, notwithstanding the sharp rise in exports in the last couple of months. The very fact that the merchandise trade deficit has gone up from less than 1 per cent of GDP a few years ago to perhaps 7 per cent-plus in the current fiscal year indicates the lack of competitiveness of the India’s manufacturing economy, at the present exchange rate. I am reminded of a recent article titled, “Determinants of Export Decision of Firms” (Economic & Political Weekly, February 12) by T N Srinivasan, professor of economics at Yale University and Vani Archana of the Indian Council for Research In International Economic Relations. I was disappointed that it did not consider the exchange rate while regressing 11 other variables. Being closely involved with firms in the real economy, I have long felt that the economics of exports, on which the exchange rate has a major influence, often has the single biggest influence on export decisions.
Also, I cannot help but comment on another article, “How India can cope with plenty?” by Eswar Prasad, professor of economics at Cornell University. (The Wall Street Journal, January 7). The focus is on capital inflows, and some of the points that Prof Prasad makes are, to say the least, curious.
Talking about the current account, he argues, “Reducing the deficit beyond a certain point would require forcing Indians to forego some of the tangible benefits of development.” What should be the priorities? Consumption of Patchi chocolates costing Rs 3,600 a kg, buying Gucci handbags and shoes, the pleasure of seeing Pamela Anderson on reality shows on Indian TV? Or the creation of reasonably paid employment for the millions who face problems in getting two square meals every day? And, it is exports that create jobs (as US President Barack Obama acknowledged in his visit to India saying the orders signed then would create 50,000 jobs in the US for the next several years); substituting the domestic output of all kinds of goods from electrical accessories, to furniture, to toys, to Ganapati idols, to power plants, with imports destroys them. And, the galloping merchandise trade deficit, particularly with China, exhibits the latter phenomenon. Sorry, Prof Prasad, but we do need to bring the deficit down; and a more competitive, managed exchange rate, is a necessary condition for this.
“Policy makers must focus on how that deficit is financed”. Many of our policy makers, to my regret, are following Prof Prasad’s advice and are complacent about the exchange rate and the deficit it is leading to, given the level of reserves and the belief that capital inflows will continue indefinitely. Too many emerging market economies have done the same mistake and suffered crises during the last couple of decades. The “music” of capital flows leading to currency appreciation, deficits on the current account and the ever-growing need for more capital inflows, unfortunately, does stop playing some time — the song lasts somewhat longer if your currency happens to be the global reserve currency, an “exorbitant privilege” which India does not enjoy.
“As for portfolio inflows, India must do a better job welcoming foreign investors who see India as a country with long-term growth potential rather than just as an opportunity to make a quick buck.” It is not at all clear how exactly one should distinguish between the two at the point of entry, particularly since, according to Prof Prasad, “policy makers must strongly resist an urge to impose capital controls to discourage short-term capital flows”.
Prof Prasad is, of course, right in arguing that “policy makers should focus on opening new pathways … for foreign direct investment”. In this year’s Budget, Finance Minister Pranab Mukherjee has overlooked this issue, even as he seems to continue to accept the other points made by Prof Prasad, as also other Anglo-Saxon economists.
I am equally puzzled by the contents of the communiqué issued after the recent G20 finance ministers’ meeting in Paris. On the issue of global imbalances, the G20 merely asked the International Monetary Fund to monitor “the trade balance and net investment income flows and transfers”. Services were omitted (why?) but transfers, which are no reflection of a recipient country’s policy, are included. Strange are the ways of the G20!
