1. Mr Governor, please explain

Mr Governor, please explain

Raghuram Rajan should make it clear why a relatively undervalued rupee is not good for the Indian economy

By: | Updated: February 18, 2016 2:28 AM
Raghuram Rajan should make it clear why a relatively undervalued rupee is not good for the Indian economy

Raghuram Rajan should make it clear why a relatively undervalued rupee is not good for the Indian economy

Monday, February 15, brought two important bits of news—one most disappointing and the second most surprising. The disappointing news was that India’s exports declined for the 14th consecutive month. I do not recall a similar sustained rout of our most employment-intensive part of the economy in recent times. Exports, which averaged $26 billion per month during 2013-14, have plummeted to $21 billion over the last 12 months. This is an average decline of more than 16% each month for longer than a year.

We will, of course, blame this precipitous regression on the terrible global conditions. Suffice it to say, that with a share of a mere 1.5% in global merchandise trade, this failure was surely not inevitable. We could try and raise our market share, as China has done by raising its share from about 1% of world trade in 1998 to 7.5% at present. India’s share has remained virtually stagnant. But that will take a concerted, sustained and coordinated effort, for which all relevant stakeholders have to be on the same page and pulling together. This seems to be increasingly impossible, with totally divergent signals from different parts of the government.

That brings me to Monday’s surprising news. This is the statement by RBI Governor Raghuram Rajan that he does not support the idea of an undervalued exchange rate for India. That did come as a shocker. Some of us—and I can without fear of misrepresenting them add names like Shankar Acharya and Surjit Bhalla to mine—have consistently argued that India will be far better off in multiple ways with a relatively undervalued exchange rate.

It makes for export optimism if businessmen can safely predict a relatively undervalued exchange; it compensates for the grossly inadequate and globally uncompetitive infrastructure and logistics services that plague our exporters; it helps attract more tourism that is hugely employment-intensive; it raises prices of imports like gold and energy and thereby helps energy conservation; and finally it also helps attract greater volumes of remittances from our NRIs who use this opportunity to build assets in India.

Given all these advantages, why would Rajan oppose the relative undervaluation of the rupee and simply pooh-pooh the achievements of East Asian countries like Japan, Korea, Taiwan and more recently China. All these economies achieved their remarkable economic performance over three decades or longer, with an undervalued exchange rate as one of the essential components of the macro-policy package. In fact, one should recall the huge pressure exerted by the US, Europe and the Bretton Woods twins on China to appreciate the yuan around 2004-05. The Chinese successfully resisted this pressure, on advice from economists certainly as eminent as Rajan and having learnt from the Japanese catastrophe of the later 1980s.

But in our case, the pressure comes from our central bank! Rajan said and I quote, “I personally believe that sustained undervaluation over a long period of time is not a feasible or desirable strategy … We want to make it reasonably predictable, reasonable stable. The advantage for SMEs must come instead from their own capabilities … from their cost effectiveness, ideas and systems … not from any exchange rate undervaluation.” (HBL, February 16). I am sure that the audience of SME entrepreneurs would have been shell-shocked at this powerful message from the pulpit.

SME exporters would have expected such a message had they reviewed the trend of the rupee’s exchange rate in the past. Economists use the Real Effective Exchange Rate (REER) to examine the real change after discounting for relative consumer price inflation (CPI). RBI, thankfully, obliges by putting out a monthly REER for the rupee relative to a composite index of 36 partner countries. A level of 100 reflects ‘neutral’ REER; figures higher than 100 reflect over-valuation and below that show that the rupee is relatively undervalued.

Before Rajan took over in September 2013, REER was below 100, at 99.5 (36-country trade weighted) in August 2013. It became higher than 100 in October 2013 (102.6), and has remained consistently higher ever since. REER is currently peaking at 113.7 in January 2016. More distressingly, the six-country REER index in January was at 124, having been 108 in August 2013. This reflects the rupee’s consistent over-valuation vis-a-vis our main trading partners during Rajan’s tenure.

So yes, SME entrepreneurs should expect stability and predictability in the rupee’s exchange rate as Rajan has declared. But going by the above record, they should expect the rupee to remain overvalued. Is that fair? Would that really spur SME exporters to try harder at achieving cost-effectiveness or would it invite capitulation and exit. The Governor may please like to explain.

But most, if not all, cost drivers are outside SMEs’ control. They have everything stacked against them. Government procedures, roads, ports, transport, electricity, labour costs as fixed costs, bribes—our valiant SME exporters climb a mountain in achieving the exports they do. So may be that Rajan, who surely is aware of all this, is pointing his guns in a different direction. As a globally reputed colleague at CPR argued in a recent conversation, Rajan does not want either the interest rates or the exchange rate, the two potent weapons in his armoury, to compensate for institutional deficiencies in the system!

By sticking to his guns, Rajan wants to force the system to focus on these structural deficiencies rather than provide crutches for a temporary spurt in either exports or aggregate growth. But surely both my colleague and Rajan know that tackling institutional and structural deficiencies is, at the very least, a medium-term phenomenon even when policy attention is focused on them and not distracted by JNU, Arunachal Pradesh and PDP. In the meantime, should exports, employment, growth all suffer and the country be faced with a worsening economic downturn from which it will be increasingly difficult to extricate it?

On the other hand, by giving exports a helping hand, the Governor could trigger a virtuous cycle of expanding exports, increasing employment, capacity expansion, higher investment and more rapid growth. Yes, an undervalued rupee may not be sustainable over three decades as others did, but will it really hurt to have our REER below 100 for the next five years and build up foreign exchange in the bargain.

To calibrate policy instruments on the assumption of ‘first best’ situation prevailing elsewhere in the system smacks of ‘puritanism’ that is usually adopted to impress others of the same ilk. It refuses to recognise that we live in the world of the second best. And in this second best world, SME exporters will suffer inordinately with an overvalued exchange rate and that will result in growing unemployment and economic downturn that would be politically disastrous. I hope that the Prime Minister and finance minister see the huge problems associated with the Governor’s stand.

The only set of players who gain with a relatively overvalued rupee are large corporates who have stacked up external commercial borrowings. Any devaluation implies higher debt-servicing charges that is denominated in foreign currencies. This set of players has a significant overlap with those who have run up massive NPAs with commercial banks and forced write-offs of more than R40,000 crore over the last couple of years. Surely, Rajan does not want to come to their aid by keeping the rupee overvalued.

Mr Governor, either please explain why a relatively undervalued rupee is not good for the Indian economy. Alternatively, please give some succour to our beleaguered SME exporters by promising them that India’s REER will always be relatively undervalued in the coming years.

The author is senior fellow, Centre for Policy Research

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