All emerging market academicians and practitioners have been brainwashed for seven odd decades about the export led, and therefore depreciation necessary path to economic development. This strategy is as useless for India today as it is old.
In today’s world, where capital flows are far larger and far more important than trade flows – it is more important to focus on capital flows rather than trade flows. For example, FX transactions on capital account are greater than 90% of all FX transactions.
Global capital available for investment is today far higher than Global imports. It is easier to attract USD 50 b of equity flows than increase exports by USD 50 b.
The marketcap of a company is a far bigger fund resource than the cash flows of the company. Even for Facebook, it was easier to acquire WhatsApp by paying USD 17 b in stock rather than cash. Large Chinese tech companies are attracting back Chinese tech talent educated in the US by giving them stock options! The larger the marketcap, the easier this is!
So, let me enumerate some of the disadvantages of Rupee depreciation.
1. The first disadvantage as correctly pointed out by Mr. Bahl is that it imports inflation. More so, in the case of India, as we are dependent upon imported energy.
2. Having got that out of the way, let me address the point of increasing exports. We will address Mr. Bahl’s point of Rupee depreciation helping attract foreign investment in a subsequent point.
Currency depreciation is advocated where a country’s trade balance is favourably impacted because of depreciation. This does not seem to be the case for India as accepted by the RBI Report on Indian Export and Import, 2013:
“Estimates show that the elasticity of India’s non-oil exports to REER is around 0.4 with a lag of one year. This is essentially because of sizeable import content of exports and slower supply responses to price changes. Similarly, price elasticity of non-oil imports is estimated to be statistically insignificant as it includes price insensitive components like gold and also fertilisers which does not have full pass-through. Furthermore, price elasticity of net POL imports is only 0.1. Even though these estimates are sensitive to the estimation methods, the time period used and the choice of variables, they indicate that the impact of depreciation of the exchange rate on India’s exports and imports is low. Estimates assessing existence of ‘J’ curve effect show that changes in both overall trade balance (ratio of exports to imports) as also in the non-oil trade balance are statistically insignificant to REER movements.”
3. Now let us address the impact on investments in general and foreign investments in particular. India needs both domestic and global capital to invest in its economic development.
As accepted earlier, Rupee depreciation results in imported inflation. This increases domestic interest rates and increases the cost of capital, which obviously has a negative impact on the viability of projects, especially infrastructure projects.
An adverse Current Account Deficit also forces the Central Bank to supply USD, squeezing out domestic liquidity and again increasing the cost of capital.
4. Rupee depreciation is a risk for foreign investors and increases for India the cost of offshore capital in two ways – the investors need to be compensated for the actual depreciation of the Rupee and also need to be compensated for the uncertainty and volatility associated with Rupee depreciation.
Persistent deficits in the Balance of Payment result in lower country credit ratings, increasing the risk premium, which reduces the availability of capital and also increases its cost.
5. Equity capital flows in global capital markets is led by indexing. Equity Funds are benchmarked to Indices and are invested according to Index weightages. The weightage of national markets in global or regional Indices is determined, among other things, by the relative size of that market in USD terms. Rupee depreciation decreases the size of our markets and the weightage in the Index. Rupee appreciation will, on the other hand, increase the weightage of India over time in emerging market and global Indices.
6. A depreciating Rupee also decreases the wealth of India and its purchasing power. One has to then give away a larger part of one’s wealth to get the same amount of dollars and this wealth depreciation has a much larger economic impact in India than the incremental value of increased exports. At a rough estimate, Indian Rupee depreciates by 4% annually for a 2% deficit in the Current Account. Assuming a GDP of USD 3 trillion, and the value of India’s capital including its natural resources at USD 30 trillion (assuming a capital output ratio of 10%), a 60 b USD Current Account Deficit will decrease the value of India’s capital by 1200 b USD!
I am not advocating a sharp appreciation of the Rupee as this will obviously create instability and chaos in many export services and industries and thenceforth into the economy.
I am however of the strong view that a long term stability of the Rupee and perhaps even a very gradual appreciation will go a long way in attracting foreign and domestic investments, decrease inflation and interest rates and also the cost of capital and improve the stock of wealth of Indian assets relative to the world.