Why a falling rupee hurts

The Prime Minister was stating the obvious when he attributed a part of the rupee’s slide to inflation. When prices in a country are higher than in competing nations, there will be pressure on the currency to adjust.

What Manmohan Singh did not care to explain was why these pressures under liberalisation were so substantial as to push down the rupee’s value from around Rs 18 to the dollar in 1991 to a point where it has consistently breached the Rs 65 mark. Does this have something to do with the particular path of liberalisation he initiated and which was followed by succeeding finance ministers cutting across party lines?

When Singh placed his case for liberalisation in his 1991 speech, his logic was simple and appealingenough. The once infant Indian industry had grown to a level where it could be exposed to competition from the rest of the world. Once it mastered this competition under familiar conditions at home, it would be able to step out and earn a prominent place for itself in the world – more so with the help of a devalued currency.

Steady devaluation

In order to provide a leg up to Indian industry, the process of currency reform included the devaluation of the rupee. Within a year of the reform process the rupee had been devalued by over 50 per cent, breaching the Rs 30/dollar mark. This buffer meant that Indian industry, at all levels, could compete on price rather than quality or branding.

While the strategy did provide a buffer in the domestic market, it did little to help create global Indian brands.

The situation was made worse by the approach to infrastructure. Although there was a severe infrastructure deficit, the strategy focused on glamorous projects rather than cost-effective ones. As the cost of infrastructure went north, it was reflected in inflation and downward pressure on the rupee.

Fdi impact

The steady devaluation meant that any long-term foreign investor would have to factor in losses in the value of the currency in any investment decision.

This made India a far less attractive investment destination for Foreign Direct Investment than most of its competitors. At the same time, it encouraged Indian industry to invest abroad with the continuously devaluing rupee offering higher returns when the profits were brought back to India.

As FDI largely stayed away and Indian industry chose to invest abroad, including taking over major global brands, the foreign exchange situation was kept under some control by Foreign Institutional Investors focusing on Indian stock markets.

As the considerations of FIIs were largely, if not entirely, short-term they were not particularly worried about the long-term devaluation of the rupee. Policymakers too went to great lengths to make Indian stock markets attractive to FIIs.

These measures included hastening the demise of regional stock exchanges, though this meant making it much more difficult for smaller, locally known industries to tap the capital market.

Risky dependence

This dependence on largely speculative short-term FII investment was always risky. Economic officials tended to brush aside this risk by arguing that the long-term trend in FII investments have been favourable.

Unfortunately, long-term trends can also change, and when these trends are an accumulation of a very large number of short-term investment decisions, the change can be very rapid.

The recovery of the US economy and the opportunities it provides for stock market investments has created just that shift in the long-term trends.

The Prime Minister can quite justifiably argue that India is not the only country that is affected by the decision of FIIs to move out of emerging markets.

But that does not explain why the Indian economy is as vulnerable to the whims of FIIs as it currently is. Indeed, the fact that the economist Prime Minister does not even think it necessary to mention this vulnerability is something the country should worry about.

Irrelevant discourse

Without adequate attention being paid to this vulnerability and the process through which it has emerged, there is an eerie irrelevance to the economic discourse surrounding the current crisis. The popular view seems to be that all that is needed is a further dose of reforms, that is, opening up more markets to foreign investors.

Even after the dismal response to the easing of restrictions on multi-brand retail, there is still little acknowledgment that FDI may simply not want to come into the Indian market.

The collapse of the rupee is a reflection of a much more serious problem of liberalisation providing high growth rates for a while, without a comparative impact on the quality of Indian products and their brand equity. This divergence between growth and quality was never going to be sustainable over the long run. And it is difficult to see growth recovering as long as the high costs and other constraints that prevent global brands from emerging from within the Indian market are not addressed.

(The author is Professor, School of Social Science, National Institute of Advanced Studies, Bangalore.)

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