Strong rupee makes the economy strong? Or weak?

Columns by S.Gurumurthy

‘The real value of the Rupee just Rs 9, not Rs 46 to a Dollar?’

‘Truly?’

This is how many reacted to that undisputed fact mentioned in the article last week ‘Petrol at Rs 30 per litre? Possible, but–’.

A few other responses were like: ‘As a young Indian I always wondered why the hell our currency is so low in dollar terms when smaller ones commanded better value’.

‘The advantage of undervalued rupee to exporters is lost by way of high imported fuel cost’ and ‘Never thought that it was the weak rupee that was attracting foreign investment.’

Some readers had asked ‘Will foreign investments and exports not go down and imports rise when rupee goes down?’ Every one was intrigued why government works to keep the rupee undervalued.

Does a strong rupee make the economy strong? - or, weak? - was the issue that seemed to torment many.

The answer is: it can do both. In one context a strong rupee can harm growth. In another it can aid growth. Whether in a given context a strong rupee is good or bad for the economy needs vigorous, continuing, debate.

But most economic issues are under-debated for want of facts and sustained interest. Strong positions are taken for or against based on views doled out from the West and echoed by the west-centric here.

That the rupee is worth five times its value in the `market' and more than the market it is the government that keeps the rupee undervalued are facts not known to most. Basic economics teaches that if rupee rises, exports come down and imports go up. Further, with foreign investment becoming a key issue, if the rupee is up then foreign investment goes down.

Why?

When rupee moves up, every dollar of investment that comes in commands fewer rupees on conversion. Thus, undervalued rupee promotes exports and investments and augments forex reserves.

With the psychological effect of the 1990 crisis still persisting, our policy makers regard exports and dollar reserves as non-negotiable issues. Hence there is a drift towards a rupee that is undervalued. This has frozen the mindset, also the currency policies.

To defreeze the situation, a debate has to be forced on how much and what quality of forex we need to keep and how to limit the role of short term global funds in our stock markets and in our forex kitty. This debate which will decide how long the rupee be kept undervalued, is precisely what is evaded.

Undervaluing currencies to promote exports or foreign investment is a recognised game of the weak against the strong. The Japan of the past did this to promote exports and China of the present does this to promote exports - also investments.

One may ask: when China plays the game undervaluing its Yuan why not India play the game of undervaluing its rupee?

No, India cannot play the Chinese game except as an emergency measure. For, there is a fundamental difference between the two. China imports less than a third of its crude requirements and India more than two-thirds of its requirements. So India's risk of the general economy turning uncompetitive because of high fuel costs is twice as high as China's if rupee is undervalued.

When the crude prices were in the range of $10 and $20 a barrel, undervaluation of the rupee did not matter. But when the crude prices have hit the roof at $70 per barrel the story of undervaluation turns a tragedy.

This tragedy merely provides the context for debating the rupee value.

Now move on to forex reserves. By keeping the rupee undervalued from around 1994 we have built a forex kitty of Rs 736000 crores. High forex reserve is a safeguard needed for liberalising the currency regime. But liberalising currency regime is necessary to achieve high forex reserves! Again high forex reserves are needed to strengthen the rupee.

But high reserves are achieved first by weakening the rupee, to strengthen it later!

So undervaluing of rupee to augment foreign exchange is a strategy to make the rupee strong again later. But a huge chunk of our forex reserve is artificial, being built out of funds that have come into stock market funds which fly off any time, without notice.

The sooner these artificial funds, which account for a quarter of the total reserves, are shed from the reserves the better it is for stock as well as forex markets.

Again, while high forex reserves are popularly seen as an asset, actually they are a liability. Our reserves are actually money lent to the US economy at cheap interest of 2% while we bring in US funds in return at high returns as foreign investment. Building forex reserves particularly through short term funds is a zero-sum game.

How can high reserves built out of short term funds protect the rupee against the very short term funds flying off from the reserve any time? How could the risky short term funds protect the rupee when they are themselves a threat to the rupee?

Undeniably, there is a clear case for a strong rupee. For a rupee valued higher than it is today. A strong rupee makes the domestic economy strong, but the external economy less strong. But the rupee will not and should not become strong overnight.

However, just as the government took 12 years to down the rupee to 20% of its real value it may take 12 years to make it equal to its real value. Indeed, the process to raise the rupee value should begin now. And further undervaluation has to stop forthwith.

India can play a strong rupee game over the next few years. For that the government has first to stop exerting to depress the rupee and allow it to appreciate when there is influx of foreign exchange by way of exports or remittances or investments.

This may deplete the forex reserves to some extent. This might help as forex yields a meaningless return of 2%. This will balance the interests of the domestic economy with the external economy.

A strong rupee will now -- repeat NOW- mean a strong economy and not a weak one.

To avoid general imports becoming cheaper we can impose additional import tariffs for which scope exists within the WTO arrangement. Will the nation debate this issue?

gurumurthy@epmltd.com