Unlike advanced economies, it is hard to ignore the significant role of exchange rate gyrations when making monetary policy decisions in emerging economies like India.
In the latest minutes of the Monetary Policy Committee meeting in June 2019 (https://bit.ly/335Vaak), some MPC members made explicit reference to changes in the rupee exchange rate and its consequent impact on imported inflation.
Unlike advanced economies, it is hard to ignore the significant role of exchange rate gyrations when making monetary policy decisions in emerging economies like India. Yet it remains unclear exactly how they impact the economy and what the appropriate policy response should be.
Conventional wisdom suggests that, for any given costs and prices, home currency depreciation could positively impact a country’s exports and growth. Insofar as a country has multiple export partners, it is the trade-weighted or effective exchange rate that matters. Of course, the concern is that costs and producer prices could well rise (imported inputs) because of home currency depreciation and, thus, what matters from a price competitiveness perspective is the real and not nominal depreciation. Thus, both inflation and non-inflation targeting central banks in emerging economies constantly have one eye on their real effective exchange rate (REER). RBI is no exception in this regard.
Nominal currency depreciations also raise costs of imported consumer goods, which could directly impact the domestic CPI. For goods that are priced in the producer countries, insofar as a country like India has multiple import partners, once again it is the trade-weighted exchange rate that matters. As the US dollar constitutes less than 10% of India’s trade-weighted exchange rate index, it appears, in the first instance, that the rupee-dollar bilateral rate that dominates news and financial markets is grossly misdirected.
Overturning conventional wisdom: In a series of academic papers over the last few years, the International Monetary Fund (IMF) chief economist Gita Gopinath and her co-authors have emphasised the prevalence of dollar invoicing in international trade. They have gone on to show that dollar changes vis-à-vis the home currency (rupee, for instance) are the main drivers of trade prices and quantities, a phenomenon they refer to as the “dominant currency paradigm” (DCP).
The DCP is likely of even more relevance to East Asian countries that are more closely connected than India to global value chains (GVCs), in which dollar trade invoicing is prevalent. However, to the extent that India is a heavy oil importer (80% of its petroleum needs are imported), and oil—like most other commodities—is primarily priced in dollars, India too is not exempt from the DCP.
Also, to the extent that many emerging economies have large external liabilities in dollars, they are likely to be especially sensitive to bilateral dollar changes, as a sharp home currency depreciation to the greenback could impact firms, both by raising the home currency value of external liabilities with negative balance sheet repercussions (if the corresponding assets are predominantly in home currency terms) as well as by reducing their ability to finance dollar debt repayments. The consequence of the home country’s depreciation vis-a-vis the dollar appreciation is to curtail international trade and negatively impact economic activity.
Therefore, other things equal, while rupee depreciation against the dollar could improve India’s trade balance and provide a degree of economic stimulus, working against this is the negative effect of higher import costs as well as a deterioration in balance sheets and tightening credit conditions due to rising debt service costs. The net effect of such exchange rate movements is, therefore, ambiguous on inflation, trade and overall output.
Conversely, while a depreciating greenback may initially help reduce imported commodity inflation, it could also lead to a build-up of foreign currency debt, hence raising a country’s vulnerability over time. Thus, while the exchange rate is certainly important for a country like India, it is unclear what exchange rate to pay closest attention to and in what direction.
Implications for policy: While there is not much a country like India can do to impact dollar invoicing of commodities in the short term, it should aim to reduce its direct vulnerability to exchange rate changes as a step towards enhancing the overall resilience of the economy against external financial shocks. But the recent announcement of a $10 billion sovereign bond issuance seems to be a step in exactly the opposite direction. The government, for its part, should also carefully consider the potential risks of currency exposure in deciding on sovereign bond issuances. If, on balance, the belief is that the benefits of accumulating external foreign currency debt (in terms of lower interest costs and less crowding out of domestic investment domestically) are worth the risks (of depreciation of the rupee vis-à-vis the funding currency and consequent adverse effects), it is advisable to spread the borrowings across a diversified basket of currencies.
Such a diversified basket would make the financial channel of exchange rate changes more dependent on trade-weighted exchange rate changes rather than bilateral ones. While the financial channel would still impact the economy in a different direction from the trade channel (i.e. REER depreciation improves trade balance, but worsens balance sheets), RBI could aim to ensure REER is broadly stable via sterilised FX operations, while the MPC can focus solely on the direct and indirect impacts of interest rate changes on inflation first and foremost, and then output.
While it is paramount RBI maintains public commitment to its inflation target as a means of anchoring inflation expectations, it should also persist with efforts to unclog the financial system and widen financial access to enhance effectiveness of interest rate transmission, while using macroprudential polices to mitigate the build-up of vulnerabilities. In these efforts, one hopes that government actions do not work at cross-purposes with RBI.
(The author is a professor at the Lee Kuan Yew School of Public Policy, National University of Singapore)