Weaker rupee is just a mirror. We must use it to provide a fillip to reforms
It needs courage to write yet another article on the rupee-dollar rate this month. Yet a friends email providing me some interesting historical data served as the required prompt. The mail brought out the interesting factoid that in 1917,one rupee was equal to $13. At the same time,Re 1 bought you 10 grammes of gold. So if one did some basic calculations to the current rates,where Rs 60 gets you a dollar and Rs 26,700 buys you 10 grammes of gold,you find that the rupee has depreciated 670 times against the dollar but 57,000 times against gold in the last 96 years. What does this tell us? Either that the rupee is grossly overvalued currently against the dollar,or that gold as an asset class is highly overvalued,or possibly a bit of both.
Text books on economics teach us that an exchange rate is a function of the supply and demand dynamics of a currency. Quite simply,the exchange rate is a function of trade balance,the interest rate differential and differential inflation expectations between the two countries. So if we take the 20-year period,1993 to 2013,the rupee depreciated from Rs 25 to Rs 60 to a dollar. During this period,the rupee appreciated against the dollar between January 2004 to about July 2007,touching its peak of under Rs 40 to the dollar,before 2008,whereafter it fell rapidly to below Rs 50. All through this period,Indias trade balance was adverse,along with higher inflation. Future expectations could have been positive,because Indias growth rate was vastly higher than the USs during this period. However,if we dig deeper,we find that FII flows swamped any other underlying factors. What happened between January 2004 and July 2007 was that we received FII inflows of over $8.5 billion a year,which increased to $17.8 bn in 2007. This strengthened the rupee to below Rs 40,despite a negative trade balance and higher inflation. The outflow of $12.2 bn in 2008 took the rupee to over 50 to the dollar.
The daily trading volumes on the global currency markets are over $4 trillion a day and can easily swamp any action that we take in India. In fact,just the quantitative easing (QE) under way in the US currently is in the order of about $85 bn a month,or at $ 1.2 tn a year,is almost 65 per cent of Indias GDP. Thus,when Ben Bernanke talked of a reduction in QE,it hit India like a tsunami,threatening a sharp reduction in the supply of dollars,and the Indian rupee immediately fell below Rs 60 to the dollar. The sharp volatility in the exchange rate,more than its level,is very problematic for business,but our negative trade balance has climbed to $190 bn a year,up from $130 bn in 2011,and the current account deficit (CAD) of $88 bn,is up from $46 bn in just 2011. Taking a 20-year view,between 1993 and 2013,inflation in India on average was 4.83 per cent higher than the US (India 6.33 per cent to US 1.5 per cent) so one could simplistically say the rupee could be at 64.2 to the dollar to just reflect pure inflation differential. This,of course,is simplistic. But a weaker rupee is not good or bad it is just a mirror. The Japanese fought the Americans in trying to devalue the yen to support exports; often the same is said of the Chinese.
So why do we hate a weakening rupee? First,sharp currency movements disrupt business planning,but second,FII flows have a strong correlation with the Sensex. Both the rupee-dollar rate and the Sensex move together with FII flows. Inflows support the Sensex and strengthen the rupee,and outflows drop the index and devalue the rupee. Thus,sentiment related to the Sensex spills over to the rupee-dollar rate.
A more structural review of our CAD highlights the importance of key import categories oil,coal,ore and gold. I understand the negative impact of a weak rupee on oil,but for the other categories,rupee depreciation may actually help us to tackle some of these issues. We have a shortage of coal and ore due to self-created internal problems,and we are buying gold above our long-range average,primarily as an alternative investment vehicle to cushion against underperforming alternative Indian asset classes. So a smooth weakening of the rupee can help us with our underlying competitiveness.
Further,our current policy stance inhibits FDI and favours FII,which increases short term exchange rate volatility. We get $23 bn of FDI,compared to Chinas $250 bn and Brazils $65 bn. This needs to change. So,to address the rupee-dollar rate,we need to affect the underlying demand-supply dynamics,that is,shift away from an over dependence on FII,encourage FDI,and use the weak rupee to address some of the problems that stymie reform in coal,ore and improving manufacturing competitiveness.
There is one more idea for the short term. As gold imports have spiked in the last few years on the basis of investment and not jewellery demand,we need to consider measures to use the investment in gold in the country. Investors will accept a good deal. Let us get the RBI to accept gold deposits,repayable in gold in India,and offer a lower interest rate than what we might offer on a sovereign bond. We could convert the gold into dollars and buy it back in the forward market to hedge our position and create some short-term dollar liquidity. In the meantime,the weaker rupee could provide a fillip to reforms on coal and ore and improve manufacturing and services competitiveness. That would structurally help the CAD. Now that would be a real blessing from a weak rupee.
The writer is chairman Asia Pacific,BCG. Views are personal