Jahangir Aziz and Kalpana Kochhar of the International Monetary Fund recently argued in this paper (July 5): "The lesson for India is that allowing the rupee to appreciate helps to cool an overextended economy without driving interest rates so high as to kill off much-needed investment.
"Resisting nominal exchange rate appreciation because of concerns over export competitiveness is counterproductive - the resulting higher liquidity and inflation will inevitably erode competitiveness by making domestic goods more expensive.
"A much more sustainable strategy would be to achieve cost efficiencies through urgent infrastructure upgradation and education and labour market reforms."
There are so many unstated but sweeping assumptions in these couple of sentences: that the economy is "over-extended" (one disagrees); that "resisting nominal exchange rate appreciation" is counterproductive (we have managed to do this extremely productively for 15 years); that nominal appreciation of the currency will not erode competitiveness (rubbish); that infrastructure upgrade and education achieve cost-efficiencies (yes, but only over the medium term; by that time, all of us will be dead anyway).
The views are of course in keeping with the illustrious record of the IMF in surveillance of exchange rate policies, one of its primary objectives under the articles of association. It found very little wrong with the policies in the South-east Asian economies, even a few months before the region was engulfed in a series of balance of payments crises, just about a decade back.
It also granted yet another loan to Argentina, a little before the currency board policy became unsustainable, had to be abandoned, and the peso collapsed to a fraction of its earlier value. As for labour market reform, it is a pie in the sky in the current political environment.
Meantime, however, it does seem that the central bank is fully in agreement with the worthy IMF economists, and continues to allow the tail of sterilisation economics to wag the dog of the real economy. Incidentally, even as our central bank keeps articulating the difficulties in managing capital flows, Vietnam, a much smaller economy, is hoping to absorb $150 bn of capital inflows over the next five years - and China probably double that!
But this apart, despite the surprisingly low deficit on the current account for 2006-07, as conventionally calculated, reported by the central bank, there are a few points worth taking note of:
The merchandise trade deficit continued to gallop last year, even before the sharp rise of the rupee in the current year. The position will only worsen significantly in the current fiscal year: the first two months' numbers evidence a rise of 60 per cent in the deficit. And, oil prices have recently crossed $76 a barrel.
The current account deficit, excluding remittances, which are exogenous to and have nothing to do with economic competitiveness, was 4 per cent of GDP. Our complacency on the issue needs to be tempered by the fact that, unlike the US dollar, the rupee is not a reserve currency.
And, quite apart from the growth and jobs lost because of the deficit, there are limits to how much red ink we can continue to sustain in the belief that foreigners are only too ready to finance it forever.
To my mind, the major reasons for the Asian crisis a decade back were overvalued exchange rates, complacency about deficits on the current account, and freedom to residents to transfer savings abroad. All of these are present, in greater or lesser degree, in our case. An additional factor was short-term external credit, supposedly not present in our case - but see the next point.
Ostensibly, our short-term credit is low, $12 bn, as of March 2007, according to the external debt statistics released by the RBI. However, "this number does not include supplier's credits of up to 180 days". It is doubtful whether even supplier credit beyond 180 days is being properly captured. (Authorised dealers have considerable freedom to approve credit up to one year, and even beyond for certain imports: do the RBI data capture this?) What could be the amount?
The aggregate merchandise imports in 2006-07 were $200 billion. From what I know from my corporate clients' position, easily half of this is coming under supplier/buyer credits. In other words, the actual short-term trade credit outstanding could well be of the order of $50 billion plus, a huge number by any standards. (In fact, in today's exchange and interest rate scenario, any treasurer not using credit on imports deserves to be sacked!)
And, the central bank seems to have no data on the changes in flows or stock. It claims to account for leads and lags in exports under "other capital", but seems to gloss over the far bigger leads and lags on the importing side.
The commerce ministry wants to go back to the old era of fiscal subsidies to exports. Surely, the Prime Minister, at least in his old avatar as an economist, knows better than anybody else the importance of a competitive exchange rate?
But such issues apart, many other myths persist: for example, "a stronger rupee is beneficial for...import-dependent exports". The diamond cutters and polishers in Surat obviously do not know this: they are closing businesses!
The fact is that for import-dependent exports, the economics depends on the value added which is, effectively, in foreign currency terms, while costs are in rupees. The margins vanish with an appreciating rupee.
Complacency on the current account just because the deficit can be financed at least for now could prove costly, particularly when many external analysts believe the equity market to be overvalued (Citigroup recently described it as the least attractive in Asia), and the escalation in wage cost, on the one hand, and the sharp rise in the rupee, on the other, are squeezing the margins even in the vaunted services export sector.
A nugget from the RBI's recently published Report on Currency and Finance, 2005-06: At the end of 2005, in REER terms, the rupee was the only overvalued currency in Asia (Index 103.7). The Chinese Index was 92.5 and Japan 79.4. Since then the disparity has gone up very significantly. We are treading on dangerous grounds.
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