Ajay Shah tracks the conversation about rupee appreciation in light of China?s exchange rate manipulations The Chinese growth miracle is not simply linked to currency games?labour law, infrastructure and openness to FDI have also played key roles

There has been a lot of talk about rupee appreciation in recent weeks. It is claimed that rupee appreciation is bad for exports growth and that RBI must trade in the rupee-dollar market so as to force the exchange rate back to, say, Rs 50 a dollar.

The first issue is about the correct location for export promotion functions. In India, the commerce ministry is charged with export promotion. It is not clear why RBI should carry cudgels on their behalf. If it is felt that subsidising exporters is a good idea, the right way to do this is to have an explicit on-budget subsidy. It is not healthy to have non-transparent subsidies wherein it is not clear as to what the expenditure being borne by the government is, in return for increased exports.

As a counter-example, exports will go up if electricity is sold to exporters at subsidised prices. That does not mean that electricity policy should be distorted to suit the interests of exporters.

But the bigger issue is that exchange rates have much less to do with exports growth than most people seem to assume. The real effective exchange rate (REER) reflects the average of rupee fluctuations against all currencies, adjusted for relative inflation. Figure 1 plots the Indian REER time series against the Indian merchandise exports time series. From 1994 onwards, the REER has fluctuated between 85 and 110. Over this period, merchandise exports have risen from $2 billion a month to $15 billion a month.

If one believed that the REER was central to export promotion, then the exports growth that has been achieved is astonishing, considering that no big REER depreciation has taken place. What is going on? The key insight is that exports growth comes from two things. First, world trade grows. When world trade does well, Indian exports do well and vice versa. This is independent of exchange rates. Second, India has been learning to export. Gradually, firms are learning how to produce at low-cost locations in India and sell goods all over the world. That is at the heart of the transformation from $2 billion a month of merchandise exports to $15 billion a month. This also has nothing to do with exchange rates.

If firms are given subsidies, they will, of course, enjoy taking them, but in the process less learning will take place about how to match the price and quality of the global market place. It makes sense for India to force firms to pay market prices for electricity, steel or the exchange rate.

The story of India?s exports growth is even more dramatic than that portrayed in the graph because Indian services exports grew even more than the merchandise exports. This is a story about infrastructure (ubiquitous cheap telecom) and human capital (building up a workforce with millions of computer programmers). This also contradicts any simple story about the impact of the exchange rate upon exports.

But what about China? It is argued that as long as China artificially forces down its exchange rate, India has to resort to similar tactics. Figure 2 superimposes the Chinese REER against the Indian REER. In both the cases, data from the Bank of International Settlements is used?this is the best REER calculation available at present.

The graph shows that the Chinese real rate appreciated by 50% from 1994 till 2010. This contradicts any simplistic story about Chinese exchange rate manipulation being the essential foundation of the Chinese growth miracle. To get to Chinese-style exports growth, we have to get to Chinese-style labour law, infrastructure, education, openness to FDI and have nearby centres of advanced capitalism like Hong Kong and Taiwan.

Why has the Chinese real rate appreciated as it has? The key lies in understanding that a country actually does not control its REER. Suppose RBI tries to perform market manipulation on the rupee-dollar market. They would do this by purchasing dollars and paying for them in rupees, trying to drive up the dollar. When this is done, rupees get released into the system, which ultimately results in inflation. When inflation comes along?as it inevitably will?the REER goes up.

In the jargon of economists, nominal instruments cannot control real outcomes. In the end, we cannot prevent REER appreciation when India becomes more productive. We can just choose whether (in addition to REER appreciation) we want it accompanied by market manipulation by the central bank and the attendant inflationary pressure.

It is hence useful to question many of the statements which are being widely claimed.

Exports growth is about the deeper problems in India, such as infrastructure or education or labour law or the GST. It is also about the world trade growth. It has very little to do with the REER. And even if it did, government has little influence over the REER. Even if RBI tries to carry out market manipulation on the rupee-dollar market, it cannot stave off REER changes since nominal instruments cannot modify real outcomes.

If the government wanted to subsidise exporters, the right place to do this is to run export subsidy programmes in the commerce ministry. The wisdom of doing this is questionable?India gains GDP growth from export orientation only when exporters compete in the world economy and match world price at world quality. If feeble exporters show fake exports propped up by subsidies such as tax exemptions or free electricity or a manipulated exchange rate, we get the pointless combination of subsidising foreign consumers coupled with a lack of productivity growth.

?The author is an economist with interests in finance, pensions and macroeconomics