Ever since the rupee started strengthening, export growth is up barely 12% cumulatively, whereas imports have grown at 30%. Photo: Bloomberg
As recently as February, the headline in a major newspaper blared that the rupee could breach 70 to the dollar. Five months later we are looking at breaching 62, in the opposite direction. Such is the volatile turn in currency sentiment.
Ever since Donald Trump won the US election in November, the American stock market has rallied, and so has the dollar. Analysts expected 2017 to be the story of the strong dollar globally. It was expected to be aided by the Federal Reserve Bank’s hike in interest rates and a one-time tax exemption for companies to repatriate their profits. This “uphill” flow of capital back into America would continue to keep the dollar strong. Indeed, the dollar index which measures the strength of the dollar against a composite of global currencies, reached a 14-year high in December. That momentum seemed to be unrelenting until the inauguration ceremony of the new president in January this year.
Seven months later, the dollar index is dramatically down by 10%. It has lost against most currencies. The Indian rupee too has gained 7% since January. India’s exports growth, which had turned positive last October after an 18-month negative streak, has started losing steam. Indeed, ever since the rupee started strengthening, export growth is up barely 12% cumulatively, whereas imports have grown at 30%.
It is incorrectly assumed that a stronger rupee only hurts exporters. Domestic industry, which may have zero exports, is also adversely affected by cheaper imports, which surge on a stronger rupee. Imports eat into the domestic market share. The index of industrial production (IIP) declined in June, showing negative growth for the first time in four years. Particularly badly affected was the manufacturing component of IIP, with 15 of 23 industries showing contraction. Some of this is attributed to the de-stocking prior to the roll-out of the new goods and services tax (GST) in July. But manufacturing is certainly affected adversely by the flood of imports from countries like China.
As it is, domestic manufacturing in India works on wafer-thin margins. With a 7% surge in the rupee, this can wipe out the entire profit margin of exporters and the domestic industry. The roll-out of GST has meant additional advantage to imports. For instance, importers who now pay interstate GST (IGST) in lieu of the earlier countervailing duty, can offset IGST against other taxes. This offset was not available earlier. Similarly, exporters who have imported components could earlier use export incentive scrips to pay for import duties. They are now disallowed from using those scrips for payment of IGST. Of course, this upfront IGST payment will be refunded on realization of their exports. But that takes time and involves delays, which means that working capital is locked up for longer. With India’s high interest rates, the extra cost of working capital can easily undo the slim profit margins.
The larger point is not just that under the GST regime imported items have an advantage, but that the ever-strengthening rupee is hurting both exporters and domestic manufacturers. It is worth recalling that the three-decade export-led growth of China from the 1980s was riding on its severely undervalued currency. Despite pressure from US lawmakers and threats of labelling China a currency manipulator, and despite the International Monetary Fund documenting the large extent of undervaluation, China continued to keep its currency artificially cheap. It was only in June 2005 that China relented, ever so slightly, by letting its currency appreciate a tiny bit.
East Asia’s export-led miracle growth was also predicated on a fixed exchange rate regime, which remained undervalued for far too long. We are not for a moment advocating these unsound practices, of either sustained artificial suppression, or a fixed exchange rate regime. The point is to acknowledge the fact that our domestic currency is now unhealthily strong for our economy. The Real Effective Exchange Rate (Reer) calculated by the Reserve Bank of India has been indicating a very high degree of overvaluation of the rupee. Even the forward curve, i.e. future value of the rupee that the market is betting on, shows rupee depreciation. The rupee remaining so strong is also encouraging importers to remain unhedged, thus increasing their risk. In case of a sudden reversal, they will face a huge outflow obligation, for which they may be unprepared.
There are those who will say that since India is a net importer, the rupee strength is net beneficial to the economy. This misses the point that a big part of our current account deficit is import of gold, which is classified as a consumption good. But a big chunk of gold imports is as an investment good, i.e. more like a capital account transaction. Second, large imports are also on account of capital goods and machinery, which are price inelastic. Third, with crude prices remaining steady, the impact on our current account deficit due to a weaker rupee will be quite manageable. The continuously strengthening rupee keeps attracting flows into the bond and stock market, leading to a self-fulfilling cycle, of higher asset prices and higher returns (in dollar terms). This phenomenon too can lead to sudden stops and reversals. Nobody can time the bursting of a bubble, but that does not mean we shouldn’t exercise some caution.
For the sake of the robust health of industry and manufacturing, and for reviving the export boom, it is essential that we bring back the rupee to a more sane and competitive level.
Ajit Ranade is chief economist at Aditya Birla Group.
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