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So why is the rupee rising?

By T C A Srinivasa-Raghavan
May 24, 2003 13:48 IST
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The last 18 months have seen a virtual explosion of that peculiarly Indian characteristic hand wringing at success. Oh God, the economists are moaning, so much food, so much foreign exchange, such a big decline in poverty? Why hast thou forsaken me, my Lord?

But this is par for the course. From Malthus onwards failure, or the prospect of it, has held economists -- my good and ever cheerful friends Surjit Bhalla and Omkar Goswami excepted -- in thrall.

So it is not surprising that there should be a new example of looking for bad news when the reasons may well be otherwise.

It pertains to why the rupee is appreciating against the dollar. Each dollar costs two rupees less today than it did 18 months ago.

The most facile reason so far has been the arbitrage one. The smart NRI crowd, say some economists, is borrowing dollars cheap and lending them to Indian banks dear and making a killing on the difference. I am sure this happens but I was not convinced about the extent.

So, since I know one or two people in banking, I asked them about it. They said the same thing: it was business as usual, no spurts. Eventually, the RBI came out with the numbers and that was that.

Another reason which economists have found attractive is investment demand. Low investment levels have meant low demand for dollars, so that their supply has exceeded demand. Whence the accretion to the reserves, as the RBI bought up the 'surplus' dollars.

This must be stopped, shouted some economists. But when I asked them, they failed to say just when it should stop.

This made their advice completely useless. So the RBI sensibly carried on until its rupees (for buying the dollars) began to run out. Now the rupee has begun to appreciate quite rapidly.

O dear, O dear, another gang is saying as a result. A higher rupee means Indian exports are more expensive. The RBI must ensure that the rupee continues to depreciate, as it has done until last year.

After all, only foreign demand can help push up the industrial growth rate. Perhaps they are right but again, to what extent? And who decides what the trade-off is between cheap imports and cheap exports?

Some of us hacks, into whose lot it has fallen to follow this angst, have been watching the confusion with increasing amusement.

The Tower of Babel was a model of clarity in comparison and, by the way, Keynes was wrong. It is not always better to be vaguely right than clearly wrong. Sometimes an economist should be precisely right as well.

Two economists who seem to have been just that were Bela Balassa and Paul Samuelson. Based on their insight, I have an alternative, and certainly more cheerful, explanation to offer. And it is this: the rupee has been appreciating because productivity in India is sharply up.

The theoretical basis for this can be found in their famous (and now massively verified) theorem, the Balassa-Samuelson Theorem. It explains why a currency appreciates.

The theorem says that as productivity in the sectors that produce internationally tradable goods increases, the wages in those industries go up.

This results, after a while, in wages in the sectors that do not produce internationally tradable goods also rising but without a concomitant increase in productivity. This in turn results in inflationary tendencies. That has an impact on the real exchange rate, which appreciates.

The core of their explanation thus lies in a divergence in national price levels, and in a sharp increase in the marginal product of labour. Countries experiencing higher rates of productivity growth in traded goods also experience a relative increase in their national price level and an appreciation of their measured real exchange rate.

Also, the difference in national price levels is most pronounced when countries with large income differences are compared.

Balassa and Samuelson were also the first to show that productivity in the sector producing tradable goods tends to grow faster than that in the non-tradables sector.

This differential is usually larger in countries with high overall growth, like India, which has been growing at around 6 per cent compared to 2-3 per cent that its main trading partners have been growing at.

So the sudden increase in supply has to be sold to foreigners, to induce whom part of the productivity gains are passed on to them through lower prices. In effect, this would amount to a real depreciation of the currency.

The problem, however, is that the lads in the sector producing non-tradables also want more and, if they are more in number, can end up pushing the rate in the opposite direction.

The empirical evidence for this is very strong. It happened to Japan which, after the fixed exchange rate system collapsed in 1971, faced a sharp appreciation in the yen-dollar rate. More recently, it happened all over East Asia.

It happened to China in the early 1990s, which responded by that savage devaluation in 1993 that triggered the collapse of 1997.

Since then, though, China has held the yuan-dollar rate constant at 8. Its forex reserves, by the way, are thrice that of India and I hear no one complaining that they are too high.

Anyhow, what I want to ask my economist friends is if this could be true of India as well. That is, does at least a part of the reason for the appreciation lie in improvements in productivity?

Would they like to get off their addiction to easy monetary explanations and do some real work instead, like measuring changes in it?

I know Isher Ahluwalia and Vivek Srivastava have separately done so and come to opposing conclusions. The former showed that reforms raised productivity and the latter showed that it has changed very insignificantly in the 1990s over the 1980s. Neither, however, has compared the tradables and non-tradables sectors.

Nor does there exist any data on wage rates in the two sectors. But I did ask around once again to find out about wage rates. It turns out that wages in all, repeat all, export businesses have increased by as much as 50 per cent over the last five years and around 90 per cent since 1993.

It would be most helpful if some economists would do a proper survey and independently verify this, as also the reasons for it.

As for non-tradables, after the largesse handed out by Inder Gujral (a 20th century Nadir Shah in my considered view) in 1997, one need hardly ask what has happened to wages there. They went through the roof and bankrupted the employers. They also thereby held back further attempts at increasing productivity in non-tradables.

It is perfectly possible that the Balassa-Samuelson explanation doesn't apply to India. But surely it is worth checking out. Just because it may contain good news, economists should not ignore it.

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