By: Deepanshu MohanSince the mid-1990s China has sustained long-term benefits in growth from an export-led manufacturing strategy resulting from a carefully managed exchange rate where the Renminbi (Yuan) remained softly pegged to the U.S. dollar (USD). An under-valued Renminbi helped the Chinese economy to increase its share of world exports from 1% in 1980 to around 14% in 2016-17. Japan followed a similar strategy to boost its exports in the decades prior to the 1990s.
However, in India’s case, a persistent appreciation (an increase in the value of a currency compared to the value of another stronger currency) of the Indian rupee (INR) in recent years has affected the development of India’s export capacity and the demand for Indian products in both regional and international markets. According to conventional macro-economic ideas, a higher valued Rupee makes the price of Indian manufactured products and services more expensive, which can hinder Indian exports in competitive markets. This is especially true for emerging markets, such as those in South and South-East Asia.
Tracking the history of the last ten years of the USD-INR parity in Figure 1 (below), one can observe the value of the Indian rupee as it appreciated against the U.S. dollar. Scholars argue that the current exchange rate reflects an overvalued Rupee. One of the reasons for this trend is increasing confidence in Indian financial markets from foreign investors who, in recent years, have invested heavily in India, in the form of Foreign Direct Investment and Foreign Institutional Investment.
A consequence of this is that increases in foreign investment boosts demand for the Rupee, which results in the value of the Rupee increasing, and this higher relative value causing the prices of India products in foreign countries to go higher over time. While a strengthening of the Rupee in the short-term indicates a growing confidence amongst foreign investors in the currency and the growth of its financial market; if India’s economic policy framework aims to promote export-intensive products across all sectors of the economy, including small, medium and large scale enterprises (through policies like Make in India), a more carefully managed exchange rate policy will be required to keep the Rupee competitive. This is particularly true when it is compared against other emerging market currencies such as those of China, Brazil, South Korea, and the Philippines, among others. Figure 1: Historical Trends from Last Ten Years of the U.S. Dollar-Indian Rupee Parity Source: Calculations from Trading Economics In analyzing currency values and exchange rates, one usually monitors the trends in a host currency’s nominal exchange rate, which reflects the actual market value of the currency, and the real exchange rate (adjusting the currency value for inflation).
If we take 2004-05 as the base year of comparison, both real and nominal exchange rates in the Indian case reflect a continuous appreciation and overvaluation of the INR-USD parity. Further, in taking the weighted real exchange rate against India’s major trading partners, the Rupee has since remained above where it stood in 2004-05. Figure 2: A Historical Ten-Year Comparison of USD-CNY and USD-INR Exchange Rate Source: Calculations from Trading Economics Compared to China (as seen in Figure 2-above), we can observe how India’s exchange rate has appreciated over time, while China has managed to maintain an under-valued Renminbi to make its currency (and its products) cheaper and more competitive in the export markets.
While the underlying factors affecting the volatility of exchange rates may differ from one country to another, it is possible to strategically manage exchange rates and keep them in alignment with the country’s production patterns, as seen in the case of China. This is a good example for countries like India to follow in 2018. Currencies of other exporting (emerging) countries like the Philippines and South Korea too have seen a drop in their real exchange rate value since 2013 which has allowed their products to become cheaper and more competitive in the global market.Maintaining a Competitive Exchange Rate PolicyIn the case of India, a more constrained or tight monetary policy is key in maintaining lower targets of inflation at both the consumer and wholesale price levels.
Going forward, it will be vital for both the government and the Reserve Bank of India (RBI) to not only manage a low inflation rate but also ensure more Rupee-USD exchange rate and keep the rising foreign capital inflows in check. One of the key lessons from the East Asian financial crises that occurred in the late 1990s is that a persistent overvaluation of emerging market currency not only affects its trade competitiveness but also makes the country more vulnerable to a currency crisis in the future. In India’s case, a persistent overvaluation has not only affected the export demand but has also increased the overall cost of goods and services imported from other countries, thereby increasing the country’s overall trade deficit and hampering growth.
In November 2017, India’s trade deficit increased to around 13.8 billion USD, the highest deficit since November 2014. Following the slump in growth caused from the effects of Goods and Services Tax (GST) and demonetization in 2017, gradual reforms in the exchange rate system during 2018 hold the key to improving India’s regional and global trade positions. A carefully managed exchange rate (INR-USD) with a gradual loosening of monetary policy (discussed here) may allow the Rupee to gradually depreciate while keeping the inflation or price levels in check. Thus, a well-managed, under-valued exchange rate system, backed by appropriate policy measures, could be hugely beneficial for India’s economic growth in 2018 and beyond.