No wonder, then, that the clamour has been for RBI to let the rupee strengthen. In May and June, the markets wanted RBI to prevent rupee depreciation by aggressively selling dollars from its foreign exchange reserves. More recently, the markets do not want RBI to prevent the rupee from appreciating by purchasing dollars. The most common argument against currency appreciation is that it hurts exporters by making their products relatively more expensive. But research by Surjit Bhalla, an economist and FE columnist, and others suggests that a weaker currency in a sluggish global growth environment does little to stimulate exports. Even so, a weaker currency is what we need in the current environmentnot necessarily to stimulate exports but to restore the competitiveness of the tradables sector.
Judgements about currency levels, as indeed about most other economic variables, need to be made on a real (or inflation-adjusted) basis. Indias relatively higher inflation rates compared to its trading partners (a problem that has only exacerbated in recent years) will mean that even if the nominal value of the rupee remains steady, it will appreciate in real terms. So, while the value of the rupee has been broadly stable in nominal terms from 2004 to 2010 (except during the global financial crisis), it has appreciated in real terms because Indias inflation rates have been higher than those of its trading partners. Both Bank of International Settlements and RBIs broad measure of real effective exchange rate (REER) show that the rupee was 5-10% overvalued during that time. As a result, Indias tradables sector, especially import-competing sectors, progressively lost competitiveness. Put simply: as costs of manufacturing goods in India increased more than in our trading partners, it has became cheaper to import than to manufacture domestically.
Supporting this analysis is a steady and what appears to be a structural deterioration in Indias merchandise trade balance since 2004-05. The accompanying graphs show the longer-term trend for Indias merchandise trade balance. This data is adjusted for net crude and gold imports. As a result, neither the increase in crude prices since 2004 nor the recent increase in quantum of gold imports distorts the data. RBI has also found a statistically significant and negative correlation relation between domestic production and imports for textiles and certain electrical machinery, implying that the loss of competitiveness of domestic manufacturers has led to the substitution of domestic production by imports.
So, what should RBIs policy for the rupee be Judging the right level of a currency is more an art than a science. It is intuitive that, ceteris paribus, a country with a faster economic growth should have an appreciating currency while the currency of a country with higher inflation should depreciate relative to that of a country with lower inflation. The rupee faces a push of faster growth and a pull of higher inflation. While the two variables do not affect the currency to the same extent, it is reasonable to assume that in the current context where Indias inflation differential (5-6%) is higher than its growth differential (2-3%), the currency should depreciate.
RBI may not be comfortable with setting a formal exchange rate target. But that should not come in the way of its managing the exchange rate more actively rather than just seeking to tamp down volatility. It should prevent that 5-10% global risk appetite driven upswings in the currencysuch as the one we saw in September when the rupee appreciated more than 7% versus the dollar. With the push from relatively stronger growth to be weaker than the pull from higher inflation, the rupee will have a tendency to steadily depreciate. RBI should allow such a gradual depreciation to restore the competitiveness of the tradables sectors. Currency is too important to be left to the vagaries of the capital markets.
The author is an analyst with BNP Paribas India. Views are personal