A weaker rupee increases imported inflation, widening the inflation differential further and pushing REER higher
Economists and observers have made several comments about the rupee in the last few months. The general thought is that a weaker rupee will help our economy and there is a worry that the ‘real exchange rate’ shows the rupee is overvalued by 21%. The impression earlier was that the new government would look for a stronger currency. Global investors have stayed positive throughout and are still so.
Before the nation engages in a massive exercise to weaken the rupee, it behoves us to debate this because the exchange rate affects the value of our stock in international fora, affects every citizen directly or indirectly, and there is a real cost to it.
Below are a few comments on the REER methodology on which the overvaluation is predicated:
* Arbitrary starting point: Using 2004-05 as a base gives us a reading of 121 but using 2010-11 as a base (the post global financial crisis era) gives a reading closer to 97, meaning a small undervaluation. Clearly, the sharp difference raises questions about the conclusion of 21% over-valuation and the methodology in its current format.
* Services: Generally, REER is calculated using merchandise trade data. But one of our most important exports is IT services. It has very different dynamics.
* Tradables: This analysis can really be done only for tradables, but exports are less than 20% of India’s GDP. Should the conclusion from such a narrow group apply for the entire economy affecting capital account transactions and imported inflation?
* Price index: The 121 REER number is based on using CPI indices for India and trading partners. It would be better to use a ‘trade deflator’ for each country in this methodology because it is based on lack of arbitrage for the tradable commodity. Since such a trade deflator is not easily available, the CPI index is used. But for the purposes of this exercise, WPI might be a better index because food is 47% of India’s CPI basket, but not of exports. WPI is at a producer level—closer to the trade stage of production rather than consumption. Using WPI differentials, the latest REER comes to 96, implying that the rupee might be little undervalued.
REER shows a high number because of generalised deflation in our partner-economies, which pushes up the inflation differential. Most central banks and governments seem to have little control over it. But in certain export sectors, there are rigidities in costs like wages, taxes, etc. Are we sure that the high REER number still applies in the domain of inflation less than 0? Since that is the most important determinant, we need to be very sure before concluding 21%.
* Productivity: This is a factor that economists acknowledge and point to Balassa-Samuelson hypothesis. In a simple corollary, a currency might appreciate because of differences in productivity. Due to lack of timely data in India, productivity could be estimated by taking real GDP growth and subtracting from it the growth in labour force. With hard data unavailable, one could conservatively use population growth and arrive at close to 5% annual productivity growth. Subtracting partners’ productivity, which could be liberally put at 2% (Conference Board pegs the US at about 1% and Japan less than 1% for 2007-12), nets 3% per year. Over 10 years, that would easily explain a REER value of 121. In fact, given that IT services are about 20% of our exports, and productivity in agriculture and manufacturing is lower than in services, our productivity differential is likely to be even higher.
* Export competitiveness: A lot of our exports are re-exports of large imports. Those aside, we have four important net exports: textiles ($30 billion), agriculture ($10 billion), pharma ($15 billion) and IT services ($70 billion)—all approximate figures.
Additionally, equity sector analysts’ study of the impact of the rupee on pharma and IT services points at the following.
* Pharma: Business fundamentals outweigh currency swings over time. Trends in Indian pharma over the last decade suggests that rupee movements have not had a material impact on either profitability or stock performance, barring near-term swings. Most companies have consistently reinvested a large part of currency gains in R&D and business development, helping them move up the value-chain and this also helps them tide over periods of rupee strength. For large companies, the sensitivity to the rupee is very small.
* IT services: Investors worry that rupee appreciation could significantly erode margins/multiples in the IT sector.
But history suggests that growth is the biggest lever and the primary driver of multiples. Trends from four periods in the past (10-25% rupee moves) suggest that currency impacts the sector only at the margin and the margins have become more resilient. We saw upgrades when the rupee appreciated and downgrades during depreciation. The BSE IT index has done well during extended periods of rupee appreciation and vice-versa.
That leaves textiles and agriculture, where there could be some sensitivity to FX. Even if they were to benefit fully from rupee weakness, it would amount to just 2% of our GDP. In fact, our overall exports growth correlates much more strongly to the world export growth than to the value of the rupee.
Of course, employment in textiles and agriculture is an honest reason. But using a broad-based blunt instrument like the FX rate, with economy-wide impact, might not be the best option. There can be more targeted help in skill development, better technology, better distribution, etc. It would be useful to acknowledge that employment in such numbers is not structurally viable so that the next generation makes informed choices of education and career.
* Reducing imports: A weaker currency can help curb import demand. But our imports are not that elastic to exchange rate—either they are part of the value-chain for re-exports, or they are essential commodities. Gold behaves like an FX-hedged investment asset. With inflexible imports, depreciation only increases the bill.
* Vicious circle: A weaker rupee also increases imported inflation, which makes the inflation differential even wider and thus REER even higher, putting us in a vicious spiral.
We are not an exporter like China or the Japan-Korea-US of the past. Our competitive strength is in exports of services, in domestic demand, and in our entrepreneurs (start-ups). It might be better to focus on our strengths and develop those further.
Finally, why can we not think of the exchange rate also partly as a vote of confidence in the growth potential of the country? If an arbitrary starting point is good enough to accept, the successive flow-clearing prices can also be accorded some respect. (Of course, some prudent reserve build-up at these prices is justifiable for a deficit EM).
These prices are also reflective of the faith and confidence foreign investors have in the leadership of the country, the central bank, and the value-added-chain contributors. Perhaps the exchange rate methodology should be augmented to include a variable for this—the growth factor. Just like a growth stock can look perpetually expensive based on traditional parameters (like Microsoft or Cisco on P/E at IPO) and thereby lead to misleading conclusion for decades, it is useful to take a rigid methodology and adjust it for the issues mentioned above.
The author is managing director & head of Markets, Citi South Asia. Views are personal