I recently came across an interesting paper titled 'The Growth Slowdown: Real Exchange Rate Misalignment, Fiscal Deficits and Capital Inflows' by Deepak Lal (University of California), Suman Bery and Devendra Kumar Pant (both NCAER).
The paper argues that growth could go to 10 per cent per annum if only the Reserve Bank were to stop buying dollars in the market and allow them to be absorbed by the economy. The argument runs as follows:
Purchase of excess supply of dollars in the market by the central bank limits the appreciation of the real exchange rate. "If it is desired that the capital inflows be absorbed into the economy, the real exchange rate must necessarily appreciate."
"The current account deficit is necessarily equal to the capital inflows that are absorbed." (Incidentally, I am somewhat confused about the precise definition of 'absorbtion': is it flows to the extent of the current account balance as stated here, or those not sterilised, even if going into reserves, as seems from other parts of the paper?)
In other words, surplus inflows which get reflected in addition to reserves are of no use to the economy -- it is as if the money has not come in at all.
This argument is correct to the extent one looks at the economy in pure savings investment terms. However, for example, DFI coming in and adding to reserves could still yield very positive results for the economy through improved technology, management practices, distribution systems, etc. China is a case in point.
To the extent the central bank sterilises the impact on the money supply of its purchases of foreign exchange, by open market operations, "the increase in investment that would have resulted if they had been absorbed will not take place."
In our case, the increase in reserves of foreign exchange over the last 3 years has been of the order of Rs 190,000 crore (Rs 1,900 billion), as against a drop in Reserve Bank of India holdings of government securities of Rs 42,000 crore (Rs 420 billion). In other words, sterilisation has occurred only to the extent of 22 per cent of reserves accretion.
The paper argues that significant growth is "foregone as a result of the non-absorption (by the economy as distinct from the Central bank) of capital inflows."
In the subsequent analysis, services are not considered, even while they have been the most buoyant part of our external economy. Again, the paper estimates "the real exchange rate that would have been established if the capital inflows... in each period were absorbed instead of being sterilised."
To any market participant, estimating price changes if supply goes up by 'x' is a very questionable proposition. (Academic research too supports the indeterminacy of market prices.) The relationships are rarely logical, linear or indeed consistent; much depends on sentiment.
Such estimation would be unrealistic even if it is assumed that other things remain unchanged, which they rarely do. Every price change itself becomes the cause of future flow and price changes.
Indeed, in market reactions, a logical or clinical separation of cause and effect is impossible -- the effect itself becomes a cause for further changes (George Soros' reflexivity).
But this apart, the argument runs that the appreciated real exchange rate would lead to higher deficit on the current account (true, but its quantification would be very difficult on any realistic basis). This in turn would mean higher domestic investments and therefore a higher growth of the GDP.
To my mind, it is the last part of the argument that is weakest. Arithmetically of course, to the extent the current account deficit is wider, so would be the savings investment gap. But, this may not necessarily lead to larger investments. The equation could as well be satisfied by lower savings arising from a combination of:
- A rise in the import of consumer goods. If this replaces domestic production, domestic output would be reduced; if it adds to consumption, domestic savings would be reduced.
- An appreciated currency would reduce the profitability of businesses competing in external markets or with imports in the domestic market. Corporate sector savings would surely be lower.
Government revenue linked to prices, excise and customs duties for example, would fall, reducing government savings (or increasing dis-savings).
In short, the appreciated currency would lead to a higher deficit on the current account but it does not follow that this would necessarily lead to higher domestic investment, let alone growth.
Another point is also worth making. Is the availability of capital alone the determinant of investment and hence growth? (To me, this smacks of the assumption in the 1950s and 1960s that the Indian economy would be on a 'take-off'path once domestic savings rose to x per cent of GDP.)
Capital may be a necessary condition, but hardly a sufficient one! How many entrepreneurs would make capital investments at least in the tradable sector, in an economy which is open and when the currency is appreciating? The open economy would mean that the output has to be competitive in third markets as also in the domestic market with imports.
If the appreciating currency makes this difficult, leading to the desired higher deficit on the current account, attractions of domestic investment fall. There is another problem. An appreciating currency would surely lead to lower, if not negative, inflation also in the non-tradeable sector, making investments less attractive. (Reserve Bank of India's Report on Currency and Finance 2000-01 had estimated the growth- maximising rate of inflation as 5 per cent).
While on the subject, it is worth spending a few moments on recalling the plight of Japan for which economy has been a lost decade in terms of growth. To my mind, one of the major problems has been the absurd exchange rate of 1995, Yen 79 to a dollar.
If an appreciating currency were to be so good for an economy, Japan should have boomed! On the contrary it led to deflation and slowdown, which continue even now.
The concluding recommendation of the paper is a "fully open ... capital account" making the rupee fully convertible and floating, but with "a ban on borrowing denominated in foreign currency." Quite apart from whether this proviso is consistent with a fully convertible rupee, the ban is proposed in order to avoid BoP (balance of payment) crises of the 1990s variety.
It is submitted that, in these cases, the foreign currency borrowings were a symptom, a corollary, the root cause being the appreciation of the domestic currency in real terms and a huge deficit on the current account -- these are suggested, in the paper, as remedies for increasing investments and growth.
In terms of the international experience it is also worth remembering that the foundation of the economic miracles of 1950s and 1960s -- Germany and Japan -- was undervalued currencies in PPP (purchasing power parities) terms.
In short, deliberately making the domestic economy less competitive through real currency appreciation does not seem a very convincing way of promoting growth!