A depreciating rupee is an opportunity, not weakness

All the opportunities available to China were also open to us. The need is for the government to set up the right incentives to make those opportunities profitable for the private sector, the rest will follow, says Sonali Ranade

From the beginning of March this year and end-May, over a period of three months, the dollar rose by approximately 20 per cent, going from R48.50 to R56.50. The steep depreciation of the rupee came after the dollar was allowed to depreciate in value against the rupee from R52 in March 2009 to R44 in March 2011: a depreciation of 18 pc in the value of the dollar in Indian markets. Why did RBI allow the rupee to appreciate by 18 pc during the 2009-11 period? Is the current depreciation in the value of the rupee against the dollar justified?

While these are valid questions, the debate on the external value of the rupee misses its salience to the broader economy. Japan, the Asian Tigers, and most recently China, have all industrialised and shown phenomenal growth rates using a cheap home currency to reorient their economies for rapid growth in exports. Indians used to be dismissive of such strategies on the plea that Japan and the Asian Tigers were "small" countries, which made an export-led growth strategy feasible. India, with a huge population and a large domestic market, needn't follow a similar strategy. 

Then came China with a population larger than ours and showed how a cheap domestic currency could be used to implement an export-led growth strategy with resounding success. Yet, we cling to tired old arguments, both unwilling and unable to export our way out of poverty. What accounts for our negative attitude to exports?

The two largest items on India's import bill are crude oil [$100 billion] followed by gold [$50 billion]. These two items account for a little over 50 pc of our import bill. We produce little of crude domestically and virtually no gold. Yet, in the world markets we are third largest importer of crude and the largest importer of gold.

An argument for keeping the rupee over-valued is that since India imports more than it exports, and as most of our imports like crude are price inelastic, India is better off keeping the rupee over-valued.

The argument is deeply flawed at many levels. Firstly, remember that our current account deficit, which now is in the region of $90 billion a year, has to be financed. In other words, the excess of imports over exports every year has to be paid for by [a] borrowing on the international markets; and/or [b] selling other assets such as equity in our profitable companies to investors abroad. Since the '90s we have been financing the CAD by borrowing from NRIs, borrowing from other international investors and selling shares in Indian businesses through FII or FDI routes. 

Note, we started with borrowing from institutional investors in the '70s. When that source ran dry we turned to NRIs. In the '90s even that wasn't enough so we started selling the family silver -- shares in domestic companies and new businesses. This is not to say FII or FDI is undesirable. But we are not doing it to foster competition in domestic markets. We are allowing such investments primarily to fund the CAD. We have no other choice.

The simple fact is, no matter how attractive a strong rupee appears from a tactical standpoint, it leaves a huge CAD in its wake that has to be funded. We have been running a persistent deficit for the last 65 years and are running out of funding options. What little advantage we may gain in "cheaper imports" via a stronger rupee is lost by having to pay higher than normal for funds with which to cover the deficit. Hence, over time, a stronger rupee debilitates the economy and the shrinking funding options is what precipitates depreciation of the rupee! 

Therefore, a "strong rupee" actually causes a profoundly deeper weakness. Furthermore, a strong rupee sends out wrong price signals to the economy and sets up perverse incentives that perpetuate the deficit instead of correcting it over time. The fact is, nations cannot persistently spend more than they earn. There is a day of reckoning when nations too can and do go belly up.

If we are running a persistent CAD that keeps growing every year, obviously deep structural changes are needed to correct the imbalance. On the import side, it obviously means curbing the use of crude and gold, to take the two largest items on our import bill.

Instead of curbing demand we subsidise petroleum, oil and lubricant products, which promotes their consumption. Similarly for gold, by keeping real interest rates negative on bank deposits we force households to save via gold rather than via financial products.  Were the real returns on bank fixed deposits positive after accounting for inflation, the investment demand for gold would disappear. But the government uses sly taxation of wealth saved in bank deposits to manage its fiscal deficit. In the process it sets up perverse incentives for gold imports. 

Elimination of subsidies on POL products would force the economy to be more fuel-efficient and cut the demand for POL by incentivising the development of other options such as solar or wind power. We often forget that subsidies hurt the larger economy by killing off innovation that would mitigate the current problem. 

Similarly, an explicitly stated policy of keeping yield on three-year fixed deposits at least one pc pa higher than WPI or CPI would not only force RBI to be more market-driven in setting interest policy but also eliminate the investment demand for gold. In fact, consistently followed, the policy could also free existing stocks for consumption demand and/or exports. 

The argument that gold imports don't hurt is absolutely fallacious. Not only are gold imports awfully deflationary, they are also far more expensive to the economy than to investors who buy if the rupee is over-valued. The notion that gold imports don't really add to the "real deficit" is equally off the mark. The privately held gold hoard is simply not available to society when needed. 

In 1962, when India was in grave difficulty over the war with China, frantic efforts to mobilise gold to buy arms mustered a paltry 30 MTs of gold. In contrast, we import about 1000 MTs annually now and our accumulated holdings must be 20 to 30 times that amount. So let's not pretend that gold held by private households is easily available for a public purpose. That is an empty slogan.

Why can't we step up our exports? Since independence, if you look at what we have accomplished by way of finding new markets for our exports, the picture is very revealing. 

In the '70s, we went to the IMF for a bailout. Increasing exports was a must. Casting about for a way out, the government discovered that unknown to it, several smart traders in Surat were importing small diamonds, using their own capital and connections, for polishing and cutting, and re-exporting them with handsome margins. The gems and jewelry industry, much like the software services industry, was born in the private sector and recognised only after it was well-established. The rest is history. 

Similarly, in the '90s a crisis forced us to devalue the rupee and the software services industry took off responding to the increased profitability that the 20 pc rupee depreciation gave them. In both, the basic arbitrage was labour cost. The gems and jewelry industry monetised cheap skilled Indian labour. The software industry followed. 

Are there no more opportunities to monetise our abundant labour? The fact is, such opportunities abound. All the opportunities available to China were also open to us. The need is for the government to set up the right incentives to make those opportunities profitable for the private sector. The rest will follow. Are our policy-makers too pusillanimous?

Vast markets for agricultural products are opening up as people with higher income move up the food chain. China is now the world's largest importer of food and its markets are not closed by quota regimes. With our cheap rural labour, that is a huge opportunity given the right enabling policies for investment in agriculture. If such exports haven't taken off it is because we have archaic laws, poor infrastructure at ports, and lack of focus from policy-makers. 

Yet, as soya exports show, nothing is impossible. It would be in the fitness of things if the current BoP crisis, and the consequent depreciation of the rupee, is used as an opportunity by the government to open up the farm sector for investment in export-oriented agriculture since we now have a huge surplus in most agriculture crops except pulses.

A depreciating rupee is an opportunity, not a weakness. Instead of being defensive, the government needs to launch a programme to educate people and business on how to benefit from it.  For that to happen, the government needs to put its own policy-making shop in order.

Sonali Ranade is a trader in the international markets