India’s demographic dividend is on the verge of becoming a curse as it is unable to create new jobs fast enough for its growing young population. A major part of the increasing agrarian distress in the country would be mitigated if the shift of population from agriculture to urban economic activities happened faster.

The contrast with China is stark. China’s per capita income and technical capacities were similar to India’s in 1990. Today its per capita income is over five times higher. It was able to get its huge population out of poverty by creating hundreds of millions of manufacturing and related urban jobs and in the process became the factory of the world. Due to rising wages, many jobs have been moving out of China to lower wage locations. What is truly disturbing is that these jobs are not yet coming to India; the preferred locations are in South-East Asia.

It is high time for serious introspection. Why is India not yet able to take advantage of its low wages and the inherent talent of its young people to get enough investment, both domestic and foreign, into job creation and value addition here for the global market? Why is the business case for such investment not strong enough?

The starting point has to be the recognition that India has no option but to do what it takes to succeed in job creation. Social stability is at risk and time is running out. Can we do some things differently which may make a material difference?

In the discussion on improving the business case for value addition and job creation in India, the critical importance of the exchange rate hardly gets any attention. The movement of the real exchange rate, the nominal rate adjusted for the differential in inflation rates with major trading partners, has a similar effect as changes in tariff rates.

A 10 per cent real exchange rate appreciation is equivalent to a 10 per cent lowering of tariffs across the board and a 10 per cent depreciation is equivalent to a 10 per cent increase in tariffs. The greater the depreciation the higher is the impact on the business case for domestic value addition. This impact is experienced not only by exporters but also by those who serve the domestic market as imports become cheaper with appreciation and more expensive with depreciation.

While India’s nominal exchange rate is market determined, unusual factors have been leading to cycles of steady real exchange rate appreciation followed by the shock of a sharp correction, and, then appreciation again. Normally real exchange rate appreciation occurs as a country’s exports rise along with increasing productivity. India’s real exchange rate appreciates not as a result of these traditional factors but due to higher capital inflows.

Capital inflows

India has been for years the largest recipient of capital inflows from its expatriate community who send remittances. In addition its stock market has been attractive enough for FIIs (Foreign Institutional Investors). Such inflows when not matched by higher rates of investment in the economy usually lead to asset price bubbles in the stock and real estate markets, in addition to an appreciation of the exchange rate and decline in competitiveness.

It is worth recalling that each of the countries which have had extraordinary success in industrialisation in East Asia, starting with Japan, followed by South Korea, and more recently China followed a policy of keeping the real exchange rate depreciated to improve competitiveness. In sharp contrast, in India the perception among political and civil society elites has been that a strong currency is a sign of economic strength and depreciation is a sign of economic weakness.

Then there is the underlying political economy question of who gains and who loses with appreciation of the real exchange rate. Appreciation is beneficial to FIIs as the gains from the increase in the prices of their stocks in India can be taken out fully. Similarly, large corporates who have foreign currency debt gain as the real debt repayment burden declines with appreciation. The wealthy Indian has to pay less for his holidays, child’s education overseas and consumption of imported chocolates and cheeses. The losers are those who create jobs as they lose competitiveness. As a result fewer jobs get created. Clearly, the polity should be favouring the producer and the creator of jobs.

Market forces, accentuated by large scale withdrawals by FIIs, have led to considerable undoing of the real exchange rate appreciation that had been taking place over the last few years. However, any benefit from this is unlikely as market participants go by expectations.

The expectation from the experience of similar past cycles would be that the real exchange rate would again undergo steady appreciation. Investments, which need a competitive exchange rate, could be seriously considered only if there is the expectation that henceforth the real exchange rate would not be allowed to appreciate.

For this, a consensus on the imperative need for maintaining a competitive exchange rate as a necessary precondition for increasing value addition and job creation in the country would be needed. This should then become a clearly enunciated policy objective of the RBI with explicit backing of the government. The policy instruments that could be used could include building up of reserves, and reviewing the liberal tax regime for FIIs as well as the encouragement of foreign currency borrowings by large corporates.

This is not to suggest that the exchange rate is some kind of a silver bullet which would lead by itself to a surge in job creation. But this is a necessary condition for improving the business case for value addition and job creation.

India’s trade deficit with China is over $60 billion. All that is being imported from China can be made in India. The challenge is to make it happen; the starting point for that has to be a competitive exchange rate with a resolve that further appreciation would not be permitted.

The writer is Distinguished Fellow, TERI, and former Secretary, DIPP.

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