The precipitous fall in the value of the currencies of the Southeast Asian economies, Russia and Brazil amongst others have rendered the rupee overvalued in real terms. This has adversely affected the Indian economy and this is reflected in the large current account deficit and the dull economic conditions.
Rise in value of REER reflects an appreciation in the value of the Rupee
The graph above clearly shows that while there has been depreciation in the nominal exchange rate, the real effective exchange rate (REER) has infact appreciated from 1997 onwards. The REER reflects the value of the domestic currency vis a vis the value of the currencies of its trading partners. It was in 1997 that the currencies of the Southeast Asian nations suffered a precipitous fall in value and also the year in which the Indian economy first suffered a slowdown in economic activity.
The depreciation of a currency has several repercussions, which could have mixed effects on the economy. The popular 'inverted J' curve leads us to believe that although initially the costs of such a depreciation may outweigh the benefits, in the long run the country tends to be much better off.
Let's take stock of the current situation in view of such depreciation in the value of the Indian rupee:
The Indian exports have been languishing for the last two years. Apart from the qualitative factors, this is due to the increasing competition from the Southeast Asian nations in the export markets. The Asian tigers, and Russia, armed with weaker currencies, have garnered a larger share of the world export markets. This is reflected in the large trade surpluses of these economies (infact the dramatic improvement in their deficit position did help their respective currencies to recover from the all time lows they were trading at). A depreciation of the Indian rupee would lead to a shift in at least a part of this competitive advantage to the Indian export firms, thus boosting Indian exports. The rise in exports will give a boost to the recovery of economic growth.
Similarly, a weaker domestic currency would make imports dearer. This will act as a barrier against imports, thus improving the trade balance. However, imports of commodities, like oil, whose demand is relatively inelastic could dilute, fully or partially, the likely improvement in the trade scenario. Although capital imports are needed for economic growth, the need to curb the deficits is more pressing because deficits have an inflationary impact and they can also lead to financial vulnerability. In case there is exchange depreciation, Indian importers would prefer to purchase locally manufactured goods. This would add to the growth in demand for goods and services, thus helping in the economic recovery.
It is evident from the graph above that, especially after 1992, the current account deficit does respond to the changes in the real effective exchange rates (using trade based weighted). A rise in the real value leads to a higher deficit, while a decline in the real value helps trim the deficit.
A weaker domestic currency would help attract more foreign domestic investment. This is so because international companies would find it more attractive to set up units in India to service their foreign units because of the cost advantages, which in the case of a strong currency could be partially or fully wiped out.
However, a major drawback of depreciation in the value of the rupee is that it will increase the burden of servicing and repaying of foreign debt of the Indian Government (which has dollar denominated debt) and those companies that have raised dollar denominated debt. This drawback is all the more amplified in the case of short-term debt as the burden is immediately felt. However, due to the prudent polices of the Indian government, short-term debt is only a fraction (3.7%) of the total external debt.
Another drawback of a weak currency is that it might dissuade foreign institutional investment (FII) from investing in the country. For example, a US FII raises $100 mn from the US markets to invest in India. He then goes on to convert the US Dollars into Indian rupees at the rate of Rs 43.35 per US$, amounting to Rs 4,335 mn. Assume that this money is invested in the BSE Sensex at a level of 4,500. Now assuming two things happen in a span of a year: The rupee depreciates by 10%, while the sensex moves up by 10%. Therefore the rupee value of the investments has gone upto Rs 4,768.5. In the mean time however the exchange rate has moved to Rs 47.685 per US dollar. If the FII were to convert his rupees (after selling the shares) back to dollars, he would receive $ 100 mn, what he started with. Given the opportunity cost of the $ 100 mn, the FII incurred a large opportunity loss.
The prospects of a weaker currency could also lead to a rush for repatriation of funds by FIIs. The FIIs are permitted to transfer money in and out of the country at will and therefore if there were a legitimate fear of a large fall in the value of currency, they may be tempted to repatriate a part of their funds. This could result in a sell off in the capital markets.
Another fallout of a weaker currency could be higher interest rates in the economy, with the help of which the central bank/Government might want to fight off the pressure of depreciation in the value of the domestic currency. Currently, for example, the Reserve Bank of India has opted to suck out the liquidity from the market to prevent speculative activity in the forex market. This has been achieved at the cost of a higher call money rate of over 9%. Sustained absorption of liquidity could sooner or later reflect in higher interest costs for borrowers, which could in turn adversely affect the growth in investments and consumption.
There are many costs and benefits attached to a stronger and a weaker currency. However, while deciding on a policy, the economic and political situation must also be factored in. In light of the current depreciation of the rupee, one must assign a weightage to the various costs and benefits and then decide whether the depreciation is desirable or not. It is most likely that there will be large support for both views.