Will RBI take its cue at its forthcoming rate review from the stance taken by the European Central Bank and Chairman Bernanke of the Federal Reserve in the previous week? Should it? It was clear that the ECB was reluctant to do more heavy lifting, in the absence of a sense of reforms or actions from eurozone governments. Chairman Bernanke, too, seemed reluctant to extend non-conventional measures, but his fiscal concerns were somewhat different from the ECB?s.
RBI?s quandary is quite evident. Despite the fourth quarter FY12 GDP growth coming in at an unnerving low 5.3%, there is a fair bit of uncertainty whether economic activity has bottomed out or whether worse is yet to come. At the same time, there is the question whether a drop in interest rates (and consequently in cost of funds for banks and borrowers, which might happen as the next step after monetary policy easing gets transmitted) is going to do very much for increasing capex and investments, or whether the widely acknowledged implementation delays are likely to bring any monetary easing effort to nought.
At the time of the annual monetary policy statement in April 2012, we had pointed to the need to take measures to break out of the vicious cycle that is reinforcing the present macroeconomic imbalances. The presumed dominance of inflation in RBI?s monetary policy response function (with the short-term growth sacrifice), combined with the fiscal side contributing to the current account deficit, has weakened the rupee, thereby feeding back into persistence of inflation, and into the fiscal deficit through lower tax and disinvestment revenues. The more growth slows, the deeper and more persistent is the rupee?s fall and the more persistent is inflation. So, despite being a risky strategy, one way to transition into a virtuous cycle is to help growth along, with RBI contributing via an environment that might foster a drop in the cost of funds, either through cutting policy rates or increasing liquidity.
There are a lot of hypotheses and assertions hidden away behind this wish. First, has the weakening rupee actually had an adverse effect on India?s inflation? Second, following a line of thinking post the rupee?s weakening since mid-2011, has the currency depreciation served to provide a stimulus that might (partially or wholly) obviate the need for a monetary policy easing, having already begun to contribute through a moderation of the vicious cycle mentioned above? Third, will a rate cut be an antidote to the slowdown or will other implementation-related factors neutralise the effects? A corollary is a look at the factors that have caused the slowdown over the past three years.
The second statement probably has the most facile resolution, as is demonstrated by the graphs. The argument is based on a construct of RBI in 2006, a Monetary Conditions Index, attempting to combine both interest rate and exchange rate channels in evaluating the stance of monetary policy. The current avatar of this argument is that the steep depreciation of the rupee is equivalent to a monetary stimulus via increasing exports. In India, exports are now (in a loose manner of speaking, the true ratio is more complicated) equivalent to about a quarter of India?s GDP.
In graph 1, panels 1 and 2 provide ready visual evidence, which admittedly might be quite spurious, of a lack of correlation, by and large between the US dollar and the rupee. Note that the rupee (with a 3-month lead) is shown in an inverted scale, where a down move is a depreciation, which should, in theory, have helped exports. Going back over a long period, since 1994, on balance, export growth has, in most years, behaved exactly the opposite, with lagged exports growth increasing following (or contemporaneous with) an appreciating rupee.
Although a large part of India?s exports are denominated in US dollars, the causal linkages should be looked at in the totality of trade in all major currencies. That?s the second panel, with export growth set off against the 6-country Real Effective Exchange Rate, REER. If anything, this just seems to make the (counter-intuitive) linkage even stronger, with the effects of inflation being factored into the REER for good measure.
India?s recent export performance is in line with this absence of a long-term positive relationship. Export growth in the latter months of FY11 and the early months of FY12 had averaged 43%, falling to an average 5% over October 2011 to April 2012. During these periods, the rupee had risen to 44/USD in early August 2011 from 47 levels in mid 2010, before falling to 53 in late December 2011 and thereafter to 56 in May 2012.
So, what might have explained India?s export performance? Panel 3 shows the uncannily close fit in the growth rates of India?s exports and global imports. In other words, India?s export performance might have been more a global volumes game than a currency one.
One reason this might be happening is that the presumed nominal advantage of a currency depreciation is mitigated by a depreciation in the currencies of its competitors, leaving much lower comparative competitiveness. India?s currency had depreciated 24% yoy (mid-June), of Pakistan and Bangladesh (textile export competitors) 10% and 11%, Brazil (auto exports) 26%, Turkey 13%, and Mexico 17%. Although very difficult to quantify, India?s higher costs due to inadequate infrastructure might have further eroded the residual currency advantage. This brings us to the third hypothesis listed above, which will be examined in the next part of this article.
The author is Senior Vice President, Business and Economic Research, Axis Bank. Views are personal