Strong rupee raises questions about India's real competitiveness

By Radhika Rao Source:Global Times Published: 2017/8/14 22:53:39

Rupee rate doesn’t reflect India’s competitiveness

Illustration: Peter C. Espina/GT

Flush global liquidity has lifted Asian currencies including the Indian rupee this year. A weak dollar has also helped in spite of rising US policy rates. Against the dollar, the Indian rupee is up 6.8 percent so far this year and is at a two-year high. In sharp contrast to being one of the "fragile five" during the 2013 taper tantrum, the rupee is one of the region's best performers this year.

The strong rupee, nevertheless, raises questions. First, what is driving this rally? Both global and domestic factors have helped. Second, markets wonder if the authorities' stance toward the rupee has changed. We suspect it has. Third, will this appreciation pose a headwind for exports and manufacturing growth? It does hurt, but other factors can mitigate the strength.

Besides a weak US dollar, both domestic and global forces have supported the economy and the rupee. Domestically, the economy's structural story continues to improve, raising potential growth. Actual growth is catching up as banks and companies continue to deleverage. Demographic benefits are likely to be complemented by wide-ranging reforms - including subsidy rationalization, Goods and Services Tax (GST) implementation, financial inclusion and the introduction of bankruptcy laws.

The twin deficits of the current account and fiscal imbalances have largely been corrected. The basic balance of payments remains in the black. Inflation is expected to settle around the targeted 4.0 percent, down from double digits a few years back.

Encouraged by this, portfolio inflows have surged by $24 billion this year, coupled with strong foreign direct investments.

Concurrently, the global environment has been conducive. Unlike the past, the US dollar and rates are still low even as policy tightening gets underway. While other major central banks signal a slow policy normalization path, emerging markets' monetary policies have diverged as softer inflation lends a dovish tilt. The resultant wide real rates have been a draw for foreign investors.

As the rupee strengthens, one question is whether the authorities' stance toward the currency has changed. Some suspect that it has. In the past, strong rupee appreciation saw officials talk down the currency to contain gains. These comments are largely absent this time. On a few occasions, officials said that an appreciating rupee reflected the economy's improving prospects and positive reforms. They added that keeping the currency weak was not ideal. Gains are being perceived as a sign of strength rather than a challenge to competitiveness. Arvind Subramanian, chief economic adviser to the Indian government, has been in a minority, highlighting the risks of strength.

By contrast, the Reserve Bank of India (RBI) appears more tolerant of currency strength. Intervention efforts have been focused on minimizing volatility rather than protecting a certain level.

Regional currencies have also appreciated to various degrees and hence the rupee is not out of line with its regional peers. Finally, the authorities have tended not to aggressively mute the rupee when its moves have been mainly dollar-driven.

The rupee is up 5-6 percent against its trading partners since late last year. A strong currency is positive for the inflation outlook, even better when accompanied by soft global oil prices. As it is, the smaller weighting of tradable goods already makes India's CPI inflation basket less vulnerable to swings in imported prices. The RBI estimates that a 5 percent appreciation in the rupee leads to a 10- to 15-basis point decline in headline inflation. This adds to a disinflationary trend that is already underway, alongside cyclical and structural improvements that will keep medium-term inflation near the targeted 4.0 percent.

Imports will be cheaper, which is positive for consumer purchasing power. But a strong currency poses headwinds to exports and manufacturing growth. History suggests that the impact on exports shows with a lag of three to four quarters. Among goods, the impact differs. Import-intensive industries fare better due to cheaper inputs. Broadly, the import content of India's exports rose to 25 percent of gross exports in 2010-11 from less than 10 percent in the 1990s, implying that a decent proportion will stand to benefit. On the other hand, industries with low levels of import dependency and higher labor-intensity are more sensitive to rupee movements.

Service exports are more vulnerable, given the limited scope of their import dependency. A strong rupee is negative for export earnings and poses a threat to information-technology exports, eating into profit margins. A report from the RBI noted that a 1 percent rise in the rupee would affect the bottom line of the information technology and business-process outsourcing sectors by 30 to 40 basis points. This adds to the headwinds from rising protectionism and tighter labor movements in key trading partner countries, especially the US.

Finally, a competitive currency would add to India's lure as a manufacturing destination. This is particularly crucial under the "Make in India" umbrella, under which the government aims to increase the manufacturing sector to GDP ratio to more than 20 percent to 22 percent of GDP over the next couple of years, from 16 percent to 17 percent at present.

While the currency affects competitiveness, it is only one factor that determines the ability of an economy to compete. Other factors can mitigate the fallout.

First, the strength in global demand matters. The correlation between global imports and India's exports is strong at 0.8, compared with less than 0.5 for currency movements. Growth in the global economy is on the mend, which along with stable regional demand, has been supportive of India's exports this year.

Second, commodity price movements are key to export earnings and they have helped this year.

Third, factors that improve productivity and thus reduce the costs of manufacturing and exports are also important - labor costs, logistical constraints, quality considerations, ease of doing business, tax systems and the regulatory environment.

Work is in progress on these fronts and success can materially lower the cost of doing business for manufacturers and exporters, notwithstanding a strong rupee.

In the short term, rupee appreciation may continue on the back of a weak US dollar and domestic positive factors. A shift in the official stance on the currency would bolster the trend but this needs to be balanced with the impact on competitiveness.

A flows-driven rally in the currency also runs the danger of reversal should risk sentiment weaken unexpectedly.

The author is an economist at DBS Bank.
Newspaper headline: Rupee rate doesn’t reflect India’s competitiveness


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