The unexpectedly low gross domestic product (GDP) growth of 5.7 per cent for the first quarter of 2017-18 and the prospect of a growth rate well below seven per cent for the entire year has quite predictably led to a flood of pundit-speak. A fairly large number of them seem to believe that overvaluation of the rupee is responsible for the slowdown and the cure, therefore, is to “devalue” the rupee. Since a one-off formal devaluation is tricky business, what they perhaps mean is that the government and the Reserve Bank of India should make a stronger effort to curb appreciation and to the extent possible push the rupee down.
In a limited sense, the pundits are right. The negative contribution of net exports to GDP in the first quarter of FY18 was the worst in the last five years. The net exports to GDP ratio plunged to -3.3 per cent from -0.9 per cent the same time last year.
In such an environment, the default policy option seems to be to impose capital controls (particularly on debt) or to cut policy rates (implicitly making Indian bonds less attractive).
However, the efficacy of these measures will depend on whether a softer rupee will actually help matters. This is related to the question of whether at this stage the rupee is significantly above its fair value.
Here’s what the RBI has to say on this issue. Its study on the exchange rate of the rupee (included in Annual Report, August 30, 2017), for instance, suggests that the INR is actually closely aligned to its fair value. (This is, incidentally, what our research team at HDFC Bank has been pointing out for a while.) If the rupee has appreciated by 5.6 per cent against the dollar so far this year, the Chinese yuan has also gained six per cent, the Brazilian real 4.2 per cent and emerging market currencies in general by nine per cent. While there are some aberrations such as the Vietnamese dong and the Sri Lankan rupee, recent movement in the INR has been in line with the global trend.
More importantly, India’s inflation differential vis-à-vis its trading partners has declined significantly in the last two years. Theory suggests that the nominal exchange rate generally depreciates to maintain competitiveness of exports if Indian inflation is higher than those of trading partners. The fact that inflation has fallen in India should at least put some exporters in a position to tolerate at least some bit of appreciation in the currency.
There’s another problem with this. Say, capital controls combined with some aggressive intervention did push the rupee down. This kind of “artificial weakness”’ can help kick the can down the road and appear to compensate for lingering structural issue for a while. Is that the right thing to do or should we get a reality check?
Take India’s information technology (IT) sector, which contributes to around 19 per cent of annual export earnings. The annual growth rate of Indian IT services (telecom, computer and information) collapsed to 0.6 per cent in the last two years from around eight per cent recorded between 2011 and 2015. While a seemingly strong currency contributed to this, this deceleration (if we were to trust experts writing on the sector) essentially reflects the domestic industry’s tardiness in climbing up the value chain in areas such as digital businesses, big data, automation and cloud technology. The Economic Survey (Volume 2, August 11, 2017) also points out that “competition from new entrants” is one of the key reasons for the slowdown in India’s IT-BPM (business process management) sector. The survey elaborates that Indian companies have lagged behind new “digital-only entrants” from eastern Europe and Latin America, resulting in a fall in Indian exports of computer services in 2016 while world computer services exports continued to grow.
While IT is perhaps an extreme example, we would claim that if we take the entire range of exports of goods and services, increasing productivity of firms in India is the only sustainable path. Firms cannot do this by themselves and government support in the clichéd but nevertheless critical infrastructure and logistics has to take a quantum leap. Let’s not flog the “overvaluation” horse too much.
Abheek Barua is chief economist and Tushar Arora is senior economist, HDFC Bank
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