Several clients have asked me over the last few days whether I agree with Swaminathan Aiyar’s argument that “the rupee is not too strong” (The Economic Times, December 22, 2010). My short answer is “No, I do not”, partly because he looks at only one side of the current account flows: exports. What about the import growth? In fact, if the proof of the pudding is in the eating, the proof of the exchange rate’s competitiveness is in the imbalance between our current external earnings and expenditure. And this, according to my estimate, could reach a horrendous figure of 7 to 8 per cent of GDP in 2010-11, representing a significant loss of output, growth and jobs. Even the current account deficit, as conventionally calculated, would be more than 4 per cent of GDP. And, this is not so much because of higher investment as this is because of reduced savings owing to a high exchange rate.
But Mr Aiyar has raised one pertinent question: which of the two real effective exchange rate (REER) indices (6-currency and 36-currency) published by the Reserve Bank of India (RBI) is more relevant as an indicator of the rupee’s competitiveness? He opts for the latter. The RBI seems to agree with him — in its policy statement of November 2, it said the rupee had appreciated 0.4 per cent on the basis of the latter index in 2010-11 up to October 22. After talking to a large number of exporters, as part of a study on the question of rupee invoicing, I am increasingly coming to the conclusion that neither really is relevant, based as they are on bilateral trade-weighted exchange rates. Perhaps we need either a multilateral exchange rate model (MERM), which takes into account competitiveness in third markets or, more readily and simply, the weights need to reflect the invoicing currencies, and not bilateral trade.
The reason is simple. If imports are more competitive than prices in the domestic market, in choosing the country from which to import, the importers will ask for prices not in their domestic currencies, but in a common currency, and then make their choices, whether to import from India, Bangladesh or Vietnam. Though the aggregate level of imports will be significantly influenced by domestic prices, the source of import will be determined by quotes in a common currency like the dollar. In other words, while the real exchange rate of a currency would influence the competitiveness of imports with domestic costs, the source of imports will depend on the prices in a common currency. Hence the argument that we need to use either a MERM index or invoicing currency weights as a proxy for MERM — imperfect, but still better than bilateral trade weights.
This argument is particularly strong in the case of countries manufacturing “undifferentiated” goods in their tradeables sector — that is, goods bought primarily on price considerations as distinct from technology, brand and so on. Such is the case of much of India’s tradeables sector. In fact, a visit to the corner shop and a look at the electrical accessories, furniture, furnishings and toys sold there is living proof of how uncompetitive our manufacturing has become with imports. Also, The Economic Times reported on December 22, “Indians find it cheaper to holiday abroad now” — and that we “import” American stars for the so-called reality shows. Not only are services like tourism and even tailoring becoming uncompetitive (it is now much cheaper to buy a made-to-measure suit in Bangkok than in Mumbai), but the Philippines is becoming an increasingly strong competitor in the BPO segment, and China in IT.
It would be foolish to ignore that once you lose a market (domestic or foreign), because of an overvalued exchange rate you may not be able to regain it even if you become competitive again. “Temporary” losses in markets can become structural and permanent; buyers get used to, and become comfortable with, other suppliers; domestic units shut down and it is difficult to revive them. One wonders whether our exchange rate policy, or lack if it, is because our authorities are pandering to financial markets, an Anglo-Saxon disease, or our need for external validation and recognition that we have “arrived”. It is sad that this should be happening under a prime minister who, in an earlier era, was the lone voice arguing for a competitive exchange rate.
But coming back to the RBI, its statement quoted above is at best disingenuous — it glosses over what happened in the previous fiscal year. By choosing a suitable starting point (and index) one could “prove” that the rupee has actually depreciated. This apart, the last two years (as also Q1 of 2007-08) represent a dramatic and substantive shift in the country’s exchange rate policy, consistently followed since the introduction of Liberalised Exchange Rate Management System (LERMS), with no public debate or even an announcement. Let us not forget that, in financial markets, the music does not play on forever; it can suddenly stop, and that can have major consequences for financial stability.