X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Enough of this exchange rate machismo - Outside View by S.S. TARAPORE
 
 
Enough of this exchange rate machismo

The rupee is overvalued. This can hurt export-oriented industries and widen our current account gap

In the present global economic scenario, large capital inflows are inevitably followed by large capital outflows which can be destabilising, particularly in the case of the emerging market economies (EMEs).

Countries that follow imprudent and inconsistent macroeconomic policies are punished as the external sector comes under pressure. In such a scenario a country cannot be too careful in its external sector management.

Key parameters

India's international assets in June 2014 amounted to $493 billion while the liabilities were $839 billion resulting in a net indebtedness of $347 billion (as against $313 billion in June 2013). Of India's liabilities, about 30 per cent relate to direct investment and 24 per cent is portfolio investment. Of the country's liabilities, 46 per cent is non-debt and 54 per cent is debt liabilities.

External debt as of June 2014 amounted to $450 billion. On a residual maturity basis, the short-term debt (up to one year) was 39 per cent of total external debt, equivalent to 55 per cent of the forex reserves.

The ratio of foreign exchange reserves to total external debt, which was over 100 per cent during the period 2004-2010, is now down to 70 per cent. While the situation at present is still comfortable it is essential that Indian policymakers use early warning signals of deterioration of the external sector and undertake timely corrective action. In particular, the short-term debt needs close monitoring.

No need for euphoria

The balance of payments current account deficit (CAD), which in 2012-13 reached a critical level of 4.7 per cent of GDP, shrank to less than 2 per cent in 2013-14 largely due to the gold import policy which resulted in a reduction in official gold imports but a quantum jump in illicit imports of gold. Again, the slowdown in the growth rate slowed imports. With the revival of growth there will be a surge in imports. Hence, there is a need to avoid excessive euphoria on the low CAD.

In today's integrated global economy, each country's domestic and external sector policies should be in sync. A high rate of growth, a low CAD, a strong exchange rate and low interest rates despite an inflation rate higher than in major industrial countries, apart from a high fiscal deficit, reflect policy inconsistencies, resulting in punishment by global markets.

If we try for a rate of growth higher than what is sustainable, given the savings rate, the CAD will widen, and the cost of financing the CAD will go up. Indian interest rates are too low and given the inflation rate differentials, lower rates will only result in a capital outflow.

Thus, before we desire lower nominal rates of interest, we have to get down the medium-term inflation rate. There is a strong rationale in the Reserve Bank of India not yielding to the clamour for lower interest rates. A strong exchange rate, low inflation and low interest rates cannot be merely desired, they have to be earned.

The exchange rate

Using the six-country trade weighted Real Effective Exchange Rate (REER) (2004-05=100) , the rupee is overvalued by 17 per cent. Despite the US dollar strengthening, the macho spirits do not accept a depreciation of the nominal US dollar-rupee exchange rate from present $1= Rs. 61-62. This is very dangerous. With large capital inflows in the recent period, there was a need to aggressively build up the forex reserves and let the rupee depreciate. In the absence of such a build-up of reserves, the country will be vulnerable when capital flows reverse.

In the first half of the 1990s, the RBI used REER as the pole star for the exchange rate. Thereafter, there was less emphasis on REER and greater emphasis on the role of the RBI in controlling volatility.

There is the well-known 'impossible trinity' of an open capital account, an independent monetary policy and a managed exchange rate. Logically, one of these three has to give way.

But in the Indian case we do not have a fully open capital account, nor do we have a fully independent monetary policy; thus, there is merit in having some exchange rate objective. One could use some sort of a General Theory of the Second Best under which we have a reasonably open capital account, a modicum of independence in monetary policy and intervention by RBI in the forex market in tune with some objectives.

Sensitise opinion-makers

While the RBI has been apprehensive of a pre-committed REER, the RBI could endeavour to base its forex intervention on some broad parameters such as inflation rate/interest rate differentials and also respond to waves of capital inflows and outflows. One hopes that Governor Raghuram Rajan will soon enunciate the philosophy of RBI's exchange rate policy.

Inflation rate differentials between India and major industrial countries in the recent period warranted a depreciation of the nominal rupee exchange rate vis-a-vis the dollar. Many influential opinion-makers, including Shankar Acharya. AV Rajwade and Abheek Barua, have concluded that the rupee is overvalued.

My own rather elementary tracking of the secular inflation rate since 1993 (the year of unification of the dual exchange rates) warrants that the current exchange rate of the rupee should be well over $1= Rs. 70. But such an exchange rate would erroneously indict the authorities for failure of macroeconomic policy. There is, therefore, a need to sensitise opinion-makers, analysts, bureaucrats and, above all, political honchos that an overvalued exchange rate will extract a heavy price in terms of an unsustainable CAD, and ruin micro, small and medium industry, which is, by and large, export intensive. Under an overvalued exchange rate policy we beggar ourselves and enrich our trading partners.

Please Note: This article was first published in The Hindu Business Line on October 31, 2014.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

Equitymaster requests your view! Post a comment on "Enough of this exchange rate machismo". Click here!

  
 

More Views on News

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

You've Heard of Timeless Books... Ever Heard of Timeless Stocks? (The 5 Minute Wrapup)

Aug 19, 2017

Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.

Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

Aug 18, 2017

Buying the index now will hardly help make money in stocks even in ten years.

Trump Takes a Beating (Vivek Kaul's Diary)

Aug 18, 2017

Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

How To Read Your Mutual Fund Account Statement Correctly (Outside View)

Aug 17, 2017

PersonalFN simplifies the mutual fund account statement for you.

More Views on News

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Aug 18, 2017 (Close)

MARKET STATS