Exchange rate ‘management’ to aid exports is passé

TB Kapali | Updated on December 12, 2019

Unfettered markets and full play of speculative forces will help deliver an exchange rate best suited for exports

Can India export its way out of the economic slowdown? Yes, as per many economic commentators. Though they recognise that such an export-led growth boost may not be that easy in the current global trade environment (that was weak even before the onset of the US-China trade tensions), they have nevertheless pointed out that a “more competitive” rupee exchange rate would provide a short/medium term exports boost, till such time the other components of GDP can stabilise and pick-up.

REER conundrum

Such assessments are, of course, in the backdrop of the oft-repeated point about how the Indian rupee — in the past few years — has appreciated quite a bit in “real” or inflation-adjusted terms (to differing extents as per various calculation methods) and, therefore, keeps Indian exports uncompetitive. (Indian exports have grown less than one per cent in dollar terms CAGR in the last five years).

Actually, when we break up the components of the “real” exchange rate of the rupee — the nominal exchange rate that is directly observable in the financial markets and the level of Indian inflation vis-à-vis trade partners (relative inflation) — one is not that sure about this “real” appreciation of the rupee.

Real appreciation of an exchange rate can happen in the following ways: nominal exchange rate appreciates even as relative inflation improves; nominal exchange rate is stable but relative inflation situation worsens; nominal exchange rate appreciates and the situation is compounded by relative inflation worsening.

Keeping the above in mind, unless the actual Indian inflation numbers at the ground level of exports manufacturing (that is, the input cost inflation actually faced by Indian export manufacturers) are much higher than that reported officially, the point about the rupee having appreciated substantially (some say 10-15 per cent) in real terms does not appear valid.

But, note here that one rare unanimous view in India is that Indian inflation — whether per WPI or CPI or whatever other index — is in the very low single digits in recent years and is also on a consistent declining trend — coming close to inflation levels in India’s trade partners.

In the past five years, the nominal exchange rate of the rupee has fallen some 4 per cent in CAGR terms (rupee down from 59/60 to the current 71 levels).

Therefore, if the “real” exchange rate has appreciated despite steady nominal rate depreciation, it seems a reasonable inference that the relative inflation position of Indian exports is not as favourable as projected.

Market realities

The foregoing arguments do not invalidate the point that a more competitive rupee could provide a short/medium term boost to the economy. The arguments are only about the “real source” of the real appreciation in the rupee. For, if we identify the correct source of the real appreciation, we may get some idea as to the magnitude of correction that may be required in the rupee to become export-competitive.

It is here that another point made in economic commentaries calls for some analysis, as to its feasibility in the financial markets of the present times.

There have been calls for “exchange rate management” as part of a sensible exchange rate policy.

One wonders how through “exchange rate management (ERM)” India can bring about the desired degree of downward correction in the rupee to push exports.

Managing the exchange rate to push it down or depreciate it means that India has to intervene in the forex markets on such a scale as to obtain the desired level of downward correction. A downward correction in the rupee would be obtained if it (rupee) is sold and foreign exchange is bought.

So, how much of foreign exchange should India be buying in the markets?

There is no simple or even complicated mathematical equation that can provide an answer to this question. One can only say that an exchange rate is the result of many diverse, complex forces acting simultaneously. All those forces are ultimately summarised in the demand for and supply of foreign exchange (counterpart rupee) on a real-time basis in the markets, throwing up a price called the exchange rate.

To depress the rupee therefore calls for creating such a level of “outside” demand for foreign exchange that can overwhelm the supply of forex. As to what is the level of demand that is overwhelming cannot be known, as pointed out, in advance. Therefore, the agency (the central bank) intervening in the markets has to effectively be an open ended and on-tap buyer of foreign exchange — for only if it is open ended can the effects of the intervention be sustained.

Now, is this at all feasible in the current market environment? What will be the monetary and economic implications of such open-ended and on-tap intervention?

India, of course, has a long history of being a large forex buyer (though not on an on-tap basis) in the markets. And, it is well accepted that the economic consequences of even that level of forex buying has not been benign, to say the least. Indeed, ironically, one of the adverse effects of such large forex buying by India is the structurally, uncompetitive cost structure of Indian exports manufacturing.

Therefore, economic history does not support this ERM idea. Controlling market prices such as exchange rates may have been somewhat doable some 30 years ago, not in today’s environment.

No intervention

Free, unfettered markets (absent official intervention) and full play of speculative forces are what can help deliver an exchange rate that is best suited for the economy — and particularly for exports. Philosophically, this may sound heretical for many. But, at least in a fairly significant downturn, Indian policymakers should acknowledge that it is not possible to manage the “impossible trinity” in international economics. Trying to manage that only produces sub-optimal outcomes.

The writer is a Chennai-based financial consultant

Published on December 12, 2019

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