Yes, Rupee Is Overvalued, But That Is No Reason To Shoot Raghuram Rajan

After 15 straight months of a drop in India’s exports, it is worth asking again: should we worry?

The answer should obviously be yes, since, even though it is possible to claim that the decline is the result of the global trade slowdown, where even export champs like China have been in decline-and-fall mode (exports down 25.4 percent in February, while India’s fell “only” 5.6 percent), the problem is that the drop in the last three months (December 2015-February 2016) has been built on top of the drop in the corresponding declines of the year before.

In other words, we are suffering a double-drop, with February’s 5.6 percent fall coming on top of February 2015’s crash of 15 percent. March will tell us how bad things are if we find another minus sign before our export figures. In March 2015, exports fell by 21 percent, in a month when shipments usually spike, and if this month too shows another fall, we should indeed worry. A further drop on a 21 percent decline last March would be cause for worry.

Who is to blame for the export disaster?

Not me, said Reserve Bank of India Governor Raghuram Rajan the other day, addressing critics who believe his high-cost money policies may have kept the rupee’s value higher than needed. A high rupee makes Indian exports costlier in a world where many countries are depreciating their currencies to boost exports.

Rajan, whose inflation-hawkishness has kept rates higher than what sluggish corporate toplines and bank bottomlines would warrant, said in his Ramnath Goenka lecture in Delhi last week (12 March):

The question is whether we are anywhere near the “Goldilocks” rate. Have market forces really taken us there? When last heard, the rupee was quoting at 67.4 to the US dollar, very much within the range of Rs 65-68 for much of 2015-16. In contrast, the real effective exchange rate (REER), a measure that shows where the nominal market exchange rate should be once adjusted for inflation differentials against a basket of currencies, was closer to Rs 74-75.

If Rajan was watching his REER, he should have let the rupee drift around 10 percent lower against the dollar. It is doubtful he is merely intervening in the currency markets to prevent volatility; he is probably trying to keep the rupee a little higher than warranted to help the fight against inflation.

However, there is no need to fault Rajan for the simple reason that exports are not really about selling cheap, using a devalued currency crutch. India’s real problem may be that it has not raised productivity fast enough to compensate for any strength in the rupee due to capital flows or other factors. Moreover, raising productivity is not a race we run with ourselves; we have to raise productivity growth faster than our competitors.

The problem is productivity is not something that can expand as fast as the rupee can strengthen in the market. Productivity needs a consistent improvement in the ease of doing business, improved infrastructure, land and labour reforms, and the creation of unified markets for agricultural and other products. These market restrictions and impediments are slowing down productivity growth in India which cannot be compensated by offering export sops.

On the bright side, it is clear that our export collapse has been accompanied by an import crash, which has actually improved our macroeconomic fundamentals, by bringing down the twin deficits that plagued the UPA – the fiscal deficit and the current account deficit (CAD).

In February 2016, the trade deficit (which is an important subset of the CAD) was the lowest in 15 months at $6.5 billion, indicating that when the world refuses to grow, India’s advantages are outweighed by the disadvantages. This is because imports fell 5.03 percent, almost as fast as exports.

During the 11-month period April 2015-February 2016, exports fell 16.73 percent and imports by 14.74 percent, and the import fall is greater because it is on a larger base.

There is a very strong correlation between import and export trends, as many exports have a significant import content (see table).

The problem is thus not about today, but tomorrow – and that is why we should worry.

The world over, countries and companies use a recession or a period of falling commodity prices to improve productivity so that they can maintain margins despite lower revenue growth. There is some evidence that India Inc has also done so, with the economy’s incremental capital-output ratio (one very broad measure of capital use efficiency) showing a fall from 6.6 percent in 2013 to 4.3 percent in 2015. But this could be a blip resulting from overcapacity built in the years before and lack of investment in the above period. We can’t be sure whether total factor productivity has significantly improved, and improved fast enough to compensate for the loss of price competitiveness implied in the rupee’s relative strength vis-à-vis competitor currencies, including the Chinese yuan.

Some companies have managed to do so. In the third quarter of 2015-16 (ended December), Reliance Industries saw exports fall by 37.5 percent, but net profits soared 42 percent, helped by higher refining margins. This means productivity and sourcing improvements in its core petroleum business helped Reliance turn the drop in oil prices to higher profits despite the loss in exports. When prices rebound, Reliance could make even bigger gains.

If more companies are able to do this, India Inc will emerge from this global slowdown stronger and more competitive.

The overvalued rupee is really a test for the Indian economy to move to a more productive plane, helped by higher government investments in infrastructure and corporate efforts to pare down debt and improve bang for every buck invested, whether borrowed or raised from shareholders.