Four weeks back, this column argued that it was both an urgent necessity to cut the peak rate of import duty on industrial goods in order to contain inflation in the face of a strong rupee, as also the most opportune time to do so. High import tariffs protect a few industries, no doubt, but penalise everybody across the board by making their inputs costlier. Further, when domestic inflation starts running at levels that are much higher than the competition, businesses find that their rupee cost of producing goods and services rise, and that their cost competitiveness erode.
For a year now, we have had inflation at between 5 and 6 per cent. Economies in East and Southeast Asia have had inflation in this period ranging from under 1 to around 2 per cent. In our export markets in North America and Western Europe, inflation has also been about 2 per cent. Indian businesses have thus lost 4 percentage points of cost advantage in rupee terms because of domestic inflation. In earlier years, our currency has depreciated by about that much against major currencies, something that would have neutralised the trade-related damage.
But in 2003 the rupee gained 5 per cent against the US dollar. Yes, it did fall appreciably against the euro and pound sterling, but what is material for us, at least in the present context, is the movement against the US dollar. Why is that? East and Southeast Asian currencies are either explicitly (eg, Malaysian ringitt) or implicitly tied to the dollar. Over the past couple of years, as the US dollar has tumbled vis-a-vis the euro, the Chinese renminbi, Korean won, Taiwan NT dollar, Thai baht have all followed the dollar down. Not only are suppliers in this region our main competition, they also form our fastest growing export market. In the west, our fastest growing export market is the USA and when it comes to services, that is our biggest market. Had the rupee climbed against the dollar we would have run the danger of being priced out of the Asian market, and the promising, but yet fledgling IT/BPO sector, might have suffered irreparable damage. So, staying with the dollar is our only course for at least the next few years. Which is why the RBI has intervened in the foreign exchange market and accumulated the extent of reserves that it has.
If we allow relatively higher inflation and have a currency that is continuously poised to float up, we serve each and every one of our businesses ill, while perhaps catering to the special needs of a few industries that do indeed thrive on protection. What has been achieved by cutting peak import duties by nearly a third (including the impact of abolishing SAD of 4 per cent)? Imports have been made cheaper, which will, without fail, curb domestic inflation. Currently, high inflation is limited to a few industries, but it was threatening to spill over into others. So, instead of continued inflationary pressures operating on cars, trucks, machinery and the like, there will be a price softening impact instead. Further, by making imports cheaper, more imports would happen, which by enlarging the trade deficit, will help absorb part of the capital inflows and take some of the pressure off the rupee in a permanent sense. Though in the near-term, the sensible nature of last week?s policy changes may actually increase capital inflows.
To be able to join and enhance the community of prosperity in the Asian region, we need to be able to step in line with the others. Curbing inflation by monetary tightening today would have been horrendously expensive and insane. The changes on the tariff front was the cheapest instrument available, which had several added benefits, including creating pre-conditions for proposed FTAs to work.
The present strength of the rupee is the beginning of a long process where rupee assets, and hence the currency itself, is gaining a modicum of acceptability amongst global investors. To stay our course on that path, it is necessary to excise the hallmarks of defensiveness born out of apprehension that still marks many of our policies. Coming of age has always been without qualification.
The author is economic advisor to ICRA Investment Information and Credit Rating Agency