Do we need an undervalued rupee?

We can practice faith-based economics,but there is the small matter of the cost of intervention,something the pro-intervention camp rarely talks about. Interventions can control the nominal exchange rate,but what about the real exchange rate,which is what really matters for exports,growth,employment and all the other good stuff. Unlike purists,I think they can in the short run,as prices are sticky and for an extended period if the liquidity injected by the interventions is sterilised.

Sadly,there are no free lunches. First,there is the direct fiscal cost as typically the interest earned on the FX reserves is less than the interest paid on the sterilisation bonds. In the 18 months from March 2007,when RBI intervened to the tune of Rs 1.8 trillion,the negative carry was around 5%. Roughly Rs 90 billion,and about 20% of NREGA! Add to this the indirect cost on the budget and the economy of the sterilisation bonds raising overall lending rates. Not to mention encouraging large speculative inflows on the expectations of further appreciation and setting off a vicious cycle of intervention,sterilisation and inflows,until the exchange rate was let go.

I am quite certain that RBI will intervene in the coming months as the IPO-related inflows surge. Such interventions are justified as these inflows are lumpy and can disrupt the market. But persistent interventions targeting a particular level of the exchange rate should be avoided. It is costly and rarely works. Undervalued exchange rate is an addiction (just look at our neighbouring country). Over the last 18 months,RBI has put us on a detoxification course by limiting interventions. Let’s not restart the bad habit.

The author is India chief economist,JP Morgan. Views are personal

Chandrajit Banerjee

India is often clubbed with other emerging economies when it comes to financial markets,including currency markets. Financial markets treat emerging economies as an asset class so that ups and downs in these markets get synchronised. But India is different from many developing economies in one respect—it has a current account deficit. In particular,developing countries in the Asian region by and large enjoy current account surpluses due to their success as export-led economies. According to economic theory,countries that run a surplus should experience an appreciating currency while countries with a deficit should see their currency depreciate. The exchange rate then acts as an equilibrating mechanism.

But this is not what happens in reality as capital inflows impact exchange rate movements. Therupee appreciated over 10% against the dollar during 2009-10 despite the deficit widening by over $10 billion. This trend continues,driven by the perception that growth prospects are stronger in emerging markets like India. Ironically,it is these currency movements that have become the biggest threat to India’s growth. In a liberalised environment,Indian businesses need to compete both in the global arena as well as at home. Competitive disadvantages like a strong currency have become a major hurdle to increasing our export share or in competing with a flood of cheap imports. This is especially hurtful to SMEs that work on thin margins.

India’s low-cost,labour intensive SME sector contributes nearly 40% to total industrial production,accounts for nearly 35% of exports and provides employment to over 30 million people in over 12 million industrial units. Its presence is overwhelming in sectors like textiles,engineering goods,pharma and processed foods. With globalisation,there is a need to integrate into regional supply chains and attract investment in sectors where more advanced countries are losing competitiveness. It will be a pity if an overvalued currency in India leads investors to choose alternative locations for their investments.

RBI data shows that the appreciation of the rupee against a basket of six major currencies has been strong. Between April 2009 and 2010,the nominal effective exchange rate of the rupee increased by 11%,with some moderation thereafter. Even more worrying is the appreciation in real terms. Inflation in India has been higher than in other countries over the last year. Its currency should,therefore,have been depreciating to offset the rise in costs. Instead,the real effective exchange rate increased by over 20% during the same period. This will certainly hurt the competitiveness of Indian industry,slow down the growth process and widen our current account deficit. While it is the stated policy of RBI that an artificial valuation of the rupee would not be done by the central bank,a pragmatic approach to the valuation certainly merits consideration by policymakers in the overall interest of the economy,not to speak of the interest of the hundreds of thousands of people employed in sectors with high export dependence.

The author is director general ,CII