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The curious case of the rising rupee
Surjit S Bhalla | May 03, 2003
Reformists in India have for long argued that the way to salvation was through lowering of tariffs to East-Asian levels, through lowering of real lending rates to East-Asian levels, and through decrease of the fiscal deficit to East-Asian levels.
All of this would allow Indian competitiveness to improve, exports to grow, and allow GDP to grow at India's potential of 8 plus per cent a year. Godot is here, if the growth of Indian exports, and the strength of the Indian rupee is to be believed.
The rupee has appreciated against the dollar in nominal terms by 4 per cent since its trough of Rs 49.1 reached in May 2002; in real terms, the appreciation is a largish 10 per cent, all in the space of 12 months.
What is going on? Indian agriculture had a dismal year and the new year has yet to bring in the rain. Industrial growth is still sluggish and stable (petering out?) at around 5 per cent.
The world economy has been in a persistent slump and global trade volume is estimated to have expanded by just 3 per cent in 2002 after staying barely positive in 2001. Indian GDP has been the slowest in a decade, but Indian exports are growing at 20 plus per cent a year.
Exports are sales to the rest of the world -- they have to be growing, to buy Indian goods in increasing volumes (and we are not talking software here, an item for which there can be a genuine demand for the Indian brand).
But the rest of the world has faced three major shocks in the last three years and while research is not yet complete, it is most unusual for the world economy to face such serial misfortune in peace time.
The first whammy came with the real consequences (cut in investments) of the dotcom crash. And just when the world bobbed up to breathe some air, it got whiplashed by global terrorism Osama style. No sooner was there some vision of business as usual when the real consequences of 9/11 started to take effect -- the US flexing its empire in Iraq.
And just to make sure that the world does not quickly see fortune, the Chinese made sure, with their authoritarian insouciance, that the SARS (Severe Acute Respiratory Syndrome) virus not only travelled widely in China, but also to the rest of the world. To put it simply, there has been gloom and doom for the last three years.
So this is the dismal demand to which India is exporting in record volumes? One would have thought that only China would have been able to export against such odds. Think again -- Indian export growth was second only to China in 2002, and at 15 per cent, had left the Koreas of the world far behind.
So Indian exports have arrived; economic reforms are complete and 8 per cent GDP growth is around the corner. But let us not be as hasty as Indian exports apparently are. Does Indian export growth pass the duck test?
That is, if it runs like a BMW, it cannot be a duck. Is it conceivable that in the historically hostile external environment that all exporters (Indian and foreign) have faced, that we have emerged as second only to China?
Is it conceivable that in a time of rich country recession, that the less than previously rich folks are increasing their consumption of 'gems and jewellery' so much that Indian exports of the same rose by about 35 per cent in 2002?
This item is not moving from a small base -- it constitutes the largest share of Indian exports, around 17 per cent or $8.0 billion in 2001.
(Another item showing an (un)healthy increase in exports is ores and minerals, up almost a 100 per cent in 2002).
If exports are succeeding while failing the duck test, a legitimate question arises -- what is going on? Let me suggest a series of explanations, which have the virtue of being consistent with the facts.
The Indian economy is a fast growing one, and one which ranks in the top ten fastest growing economies over the last two decades. During the last three years its growth has averaged above 5 per cent, again putting it in the top league.
The last two global recession years have not been so kind to other economies, particularly western economies.
Ten-year bond yields in the US are trading below 4 per cent; three-year paper is trading below 2 per cent; the US equity market has been on a long road to nowhere (mostly down). What is a poor rich investor to do?
There is one place in this universe where government guaranteed deposits were yielding upwards of 9 per cent in 2001 and 2002 -- the infamous 'scam savings' postal savings deposit schemes of India.
These schemes are 'regulated' by the central government and have 'restrictions' on who can invest.
These schemes are also the lifeline, yes lifeline, of state governments who are so strapped for cash that they cannot pay the wages to their (legal) employees. Why don't these governments borrow from the market?
They are not allowed to do so. Why don't they borrow from the RBI? They can, but the RBI refuses to lend to them because their debt is too high, they are corrupt, and they spend on 'frivolous' projects.
So poor rich foreign investor seeking high returns (remember East Asia in the mid-nineties?) meets poor state Government of India whose only asset is to offer juicily high returns guaranteed by the central government of India -- as good as gold.
The inflow of dollars stops the depreciation of the rupee, and gets it to appreciate.
Why is there no demand for dollars to balance things out -- because India still has capital controls and is advised to do so by the International Monetary Fund, which has stopped believing in capital account convertibility but still believes in reduction of fiscal deficits -- go figure that out, but read first the Kafkaesque nature of the IMF reasoning below.
Why does India still have capital controls? Because we are waiting for fiscal deficits to come down. But if state governments can 'freely' borrow from abroad why should they stop increasing their expenditures and therefore stop increasing their deficit?
They should not -- and they don't, which is why the fiscal deficit keeps going up and makes a mockery of the Government of India Tarapore committee recommendations of not removing capital controls until the fiscal deficit is 'manageable'.
Capital controls mean that the rupee appreciates (excess demand for Indian rupees), and as the rupee appreciates, the foreign investor now finds that she has an even greater appetite for Government of India assets administered by the state governments.
So gems and jewellery show a large increase, India registers the fastest growth in exports, the rupee gets stronger and stronger, and state governments are hesitant to lower interest rates on scam deposits because how then will they fund their current expenditures. It does not get scammier than this.