In an era of free capital flows, it is difficult to say what level of reserves would be just right for the economy By Kiran Nanda
India Inc.in a recent meeting with the PM Modi and his team urged the government to allow the Indian currency to depreciate further with a view to maintain its competitiveness in global trade. There is a need to examine the appropriateness of such a demand.
Indian rupee has been lately declining as a sell-off in riskier assets deepened amid concern over Asia’s growth outlook. Regional currencies slumped with most equity markets retreating after a preliminary seeing of Chinese manufacturing sinking to the lowest level since 2009. This indicated that a slowdown in the world’s second-largest economy has been worsening. Besides, conflicting signals from the FED on when it will begin raising interest rates further dampened demand for emerging-market assets. Asian Development Bank has also cut its growth forecasts for the developing economies, including India.
Almost two years back, when Dr Rajan took over as Governor of the Reserve Bank of India (RBI), the rupee started plunging, due to the apprehensions about the possible impact of the end of monetary easing in the US. Dr Rajan by his prompt measures brought stability to the rupee’s exchange rate. Dr Rajan has been praised for creating a ‘bulletproof ’ external balance sheet, on the back of a record forex reserves.
But is the quantity and especially the quality of our reserves such as to meet the description of being ‘bulletproof ’? There is no formal ‘model’ to determine the adequacy of reserves. Some time back it was believed that reserves should be able to finance about six months’ imports. Later, the outstanding short-term credit was added to it. In an era of free capital flows, it is difficult to say what level of reserves would be just right for the economy.
Recent experience of China, by far the largest global holder of reserves of foreign exchange, is worth noting. In the wake of the stock market plunge there was a sharp flight of foreign portfolio investors in the Chinese market. The yuan fell both in the offshore, and the domestic market, despite huge selling of dollars by the Chinese central bank. China has tightened capital controls to check capital flight from the country. In an era of liberal capital account, there is a need to look at adequacy of reserves not only from the ‘flow’ aspect but also from the ‘stock.’
India’s forex reserves are not built out of the surplus of income over expenditure as in China’s case i.e. the current account surpluses but from a continuously rising external liabilities. The quality of the Indian forex reserves needs further improvement.
This time the rupee closed at 2-year low of 66.16, tracking the losses in the Asian currencies market. Most Asian currencies closed lower. Malaysian Ringgit was down 0.7%, Taiwan Dollar 0.31%, Thai Baht 0.3%, Indonesian Rupiah 0.25%, Singapore Dollar 0.17%, South Korean won 0.12% and the Philippines Peso 0.1%. However, the Japanese Yen was up 0.51% and China offshore spot 0.17%. The Indian rupee has shed almost 5% against the dollar since the beginning of 2015. The further currency depreciation may not bebeneficial for the Indian economy.
Indian IT firms, seen as the prime beneficiary of a weaker domestic currency, will not be benefiting much, especially when quite a number of them have built their non-dollar revenues. It’s estimated that around 30-50% of Indian IT firms revenues are from non-dollar revenues.
Interestingly, not all currencies have been moving in the same direction. This is due to divergent monetary policies followed across the globe. While the FED’s impending rate is strengthening the dollar, the European Central Bank (ECB) and China’s expansionary policy is weighing on the euro and yuan.
There are scanty signs of any improvement in the trade numbers. Exports have continued to fall for the last nine months. India’s domestic savings would continue to be less than domestic investments, translating into deficits on the current account in the near future.
Since the exchange rate currently trades outside 63-65 range, the rupee needs to be shored up and not to be weakened
The communique issued at the end of the Group of Twenty (G-20) meeting of finance ministers and central bank governors in Istanbul some time back reiterated the “commitment to move towards more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments. China, India and some other G-20 countries, which intervene regularly in the exchange market, signed this without batting an eyelid. This is an indicator of how seriously the G-20 members take such commitments.
Separately, India’s finance minister has emphasised that “it is the real economy that is going to matter. That is what will dictate both the currency valuation and the stock market itself ”. “I have always gone in for a relatively more rational middle path, which is the currency must find its own value”.
In a recent ‘Project Syndicate’ article, Prof Barry Eichengreen has also advised the Chinese authorities to “start developing stable and liquid financial markets that are not subject to official manipulation”.
While the draft Indian Financial Code is specific about monetary policy, it has not much to say about the exchange rate policy. Surely, the external value of the rupee should be considered as important as its domestic counterpart.
Even the power of exchange rate to boost exports has become a questionable proposition, especially as greater integration in global value chains is resulting in exports being less reactive to currency weakness. As India is focusing to be a part of global value chains, the domestic currency cannot be allowed to remain too strong or too weak. A weak currency would increase the cost of inputs utilised in final production, thereby resulting in lowering of the competitive gain. Further, significant rupee depreciation can impact the profitability of companies that have borrowed dollar loans (since rupee weakness will increase their dollar-denominated liabilities).
Hence, there is a case to maintain the rupee around its competitive rate, which might be 63-65. Since the exchange rate currently trades outside this range, the rupee needs to be shored up and not to be weakened. There is the need to distinguish between the real economy and transient factors. Developments like the Chinese devaluation of yuan and the US Fed’s likely interest rate hike are “transient” in nature. Only the real economy over time will influence the currency rate fluctuations and markets in India. As compared to the rest of the world, India is relatively on a sound footing. India’s manufacturing and services sectors have already begun picking up. This is being aided by the authorities’ focus on strengthening the real economy rather than crying over the market volatility. The best course would be to undertake and accelerate the crucial unattended structural reforms thereby strengthening the nation’s real economy parameters in manufacturing, infrastructure and service sectors and boosting the gainful employment in the country.
Appropriately, the communique issued at the end of the recent G-20 meeting showed that the big economies, including India and China, have committed themselves to refrain from taking the path of competitive devaluation. Instead they called for moving towards market-determined currency rates. The currency wars between the two biggest economies in the world have just begun. Competitive devaluation will lead to greater protectionism as more governments across the world pursue what economists describe as “beggar thy neighbour” policies, meaning policies through which one country attempts to remedy its own problems by means that tend to worsen the economic problems of others.
Latest Chinese massive devaluation has on the surface tilted the tables somewhat towards the need for the rupee to depreciate. However, this step needs to be avoided. Instead, specific industries that get adversely affected by the yuan’s unexpected mega measure can be given some booster shots in a number of other ways.
Thus, the rupee should remain range bound around its competitive rate at around 63-65. There is also a persistent demand for the Indian Rupee to be adopted as an international currency of trade, at least by its neighboring nations. This, of course, is not likely to happen soon but moving towards such a goal implies the Rupee should get strengthened and not weakened. When the Chinese currency is seeking to be part of international currency reserve system, it is high time the Indian rupee becomes strong.
Written By: Kiran Nanda