There isn’t anything inherently wrong in a rising or falling rupee. The state should not intervene.
The Indian rupee has fallen by almost 13% YTD against the US Dollar so far in this year. 2018 is thus likely to be the third-worst year for the rupee in the last 25 years. There has been a demand for the RBI or the Government to step in and stop further fall in the currency. There has been talk of floating an overseas bond issue like in 2013 to stop the rupee’s depreciation. The government has already taken some (feeble) steps to defend the rupee and there is talk of more steps, should there be a need.
Implicit in all this is a presumption that there is a fair value for the rupee that it has crossed, and this needs to be stopped. Implicit also is that a fall in the rupee’s value relative to the US Dollar is not good for the country. However, neither of these presumptions are valid. Indeed, it can be argued that the rupee’s depreciation is a good thing on balance.
In any case, unless the fall in the value of the rupee is a clear and present danger to the economy, the rupee’s level is best set by the market. And we are nowhere near crossing that threshold. For the time being at least, neither the rupee or the Indian economy needs any protectionism.
The philosophical problem of defending the currency
Does the rupee have a ‘fair value’ that the Government or RBI can calculate? This presumption itself is problematic because, of course, we cannot objectively determine the fair value of a currency. Depending on whether a person is consumer or producer or importer or exporter, his perception of the fair value will vary.
The best way to deal with such competing claims is to let those claims fight out in the market, and everybody takes the outcome as ‘fair’. The rupee having fallen 10 or 15% is by itself no indication that the exchange rate is now well past its fair value. Who is to say the rupee was not over-valued before and is fairly valued today?
The other issue embedded in this is of moral hazard. Even if there was an objective way of determining the fair value of a currency, will policymakers themselves be objective? Can they be objective? Is it better to trust the market than the bureaucrats?
The rupee’s fall and our path-dependent minds
It is very interesting to note the context for the rupee’s fall this year. At the end of last year, the Indian rupee was close to its all-time high, on average against its trading partners, in real terms (real effective exchange rate or REER). Let this sink in – the rupee was not just strong before the start of the fall this year, it was the strongest ever (since 1994, when the data begins). And even after the fall this year, the rupee is still stronger than average –indeed stronger than it has been on more than 80% of the times since 1994.
The reason why this has happened is that in the last five years, the rupee has appreciated against most emerging market currencies and even some developed market currencies like the Euro or British Pound. In a sense, thus, all that this year’s depreciation has done is reduce some of the appreciation of the last 5 years. But since that appreciation was gradual, it went unnoticed. As this depreciation has been abrupt, it is being noticed.
This reinforces the fact that financial market participants are path-dependent and not level-dependent. A stock that doubles and then falls by 50% would appear to have done worse than a stock which has gone nowhere during that time. I suspect people are reacting more to the path the rupee has taken to reach its current level rather than to the rupee’s current level itself.
The exchange rate is an elegant way of re-establishing equilibrium on the external account
After looking at philosophical and behavioural issues, let us look at the more fundamental aspect of the rupee’s fall. India faces structurally high current account deficit, and the situation has worsened in the last several years. While India’s current account deficit fell sharply post-2013, the adjustment was incomplete due to the sharp fall in global oil prices. And perhaps the adjustment was also incomplete because the rupee appreciated sharply against most currencies as highlighted above. Thus, India’s external account balance excluding Oil in FY18 was at the same level as FY13, and close to a two-decade low. The point is that while oil prices induce volatility in India’s external account, excluding Oil, India has seen a structural worsening of the external account. The improvement in India’s current account post-2013 was in a sense temporary – it sustained as long as oil prices were low globally. Now that oil prices are back up, we are once again faced with a high current account deficit (which could touch 3% of GDP or the third highest in the last 25 years, in the current year).
So, faced with a structural worsening of its external account, what can a country do? It has just 3 choices, in my view:
- It can focus on structural reforms that improve domestic productivity (which basically means removing domestic barriers to trade). This will allow it to import less or export more or import more but export even more and reduce its external vulnerability. However, this can only work in the long run. And the track record of successive governments in this regard has been less than satisfactory. This is part of the reason why the need for this piece exists!
- The second is to curb imports through quotas and tariffs, and boost exports through incentives. This is the standard response of policymakers these days even in developed countries. The problem with this, of course, is that it creates distortions. When the government says there are ‘wasteful’ imports that ought to be curbed, the government is essentially saying it will determine what the citizens of this country should import and what they should not. When the government imposes tariffs on say the steel industry to reduce steel imports, it is essentially imposing a tax on every industry that consumes steel. When the government says it will provide incentives to say the software exports at the expense of other exports, it essentially is making a value judgement. And that is a highly slippery slope. Oh, and picking and choosing industries to impose tariffs or quotas or to provide incentives encourages rent seeking.
- The third and the best in the short-term at least is to do nothing and let the market sort the problem out. By taking the value of the currency down, the market is trying to re-establish the equilibrium between domestic producers and overseas producers. And it does so in a non-distortionary manner. The market does not choose between computer chips and potato chips, nor does it choose between goods exports or services exports. It does not say we should export more or import less. It just resets the relative costs between overseas producers and domestic producers, and leaves the decision of what to import or consume less or what to export more to every individual and business in the country.
Isn’t option 3 the most elegant way of getting the external account back on track?
Of course, this does not mean that a case for intervention in the currency market can never be made. But the case can only be made when the costs of non-intervention are high and far outweigh the benefits from letting the markets sort things out themselves. Given India’s low external debt, especially low sovereign external debt, we are nowhere near that threshold being reached. Yes, inflation might rise and that might warrant higher interest rates. But a 50-100bps higher interest rates by itself is not a sufficient reason to intervene and defend a certain level of the rupee. Yes, some corporates would have the unhedged exposure that they would come under stress. But currency risk is part of normal business risk that a firm has to deal with.
Two final points before I close:
- The first is that there is a general presumption that if policymakers decide to, then they have the ability to defend the exchange rate. This belief can itself be questioned. And the cost of a failed intervention to a central bank’s reputation is very high. So, the risks that a currency depreciation poses should be grave enough for a central bank to be willing to put its reputation on the line.
- Secondly, it is also the case that if every time there is volatility in currency markets and policymakers try and smother than volatility, this creates a perception of there being a policy put against exchange rate risk. This will actually encourage more risk-taking setting the stage for a bigger and more painful adjustment eventually.