India has had a persistent, chronic, and large foreign trade deficit since Independence, averaging between 2-3 per cent of the GDP. Over and above the trade deficit, which has to be financed by borrowing dollars overseas, the Indian economy has often faced a paucity of domestic savings, with frequent borrowings abroad to finance development expenditures at home. This adds anything between 2-3 per cent to the foreign exchange deficit in the economy.
In an ideal world, the price of dollars in the market would be set at a level that balances out trade flows – that is, it clears the market as far as trade induced flows are concerned. Regular imports would then become self-financing through dollars earned from exports. However, the Indian system of accounting for and regulating foreign exchange flows results in equating earned dollars with borrowed dollars on the supply side, leading to a persistent upward bias in valuation of the Indian rupee, which has a deleterious effect on the economy. We examine the cause and effect of such a systematic bias baked into the system while evaluating the external value of the rupee.
Calculating rupee’s external value
The Reserve Bank of India (RBI) regulates the external value of the rupee by nudges, if not actual intervention, through the Real Effective Exchange Rate (REER), which calculates the rupee’s external value in relation to a basket of currencies weighted by trade volumes. The base year for these calculations is 1993.
In effect, the system assumes that the Indian rupee was somehow correctly aligned against its main trading partners in 1993. Since then, the system takes into account inflation differentials between India and its trading partners, using the Wholesale Price Index (WPI) for India and headline inflation for trading partners. By this formula, the Indian rupee typically depreciates against the dollar by 2-3 per cent per annum, reflecting the difference between WPI and inflation abroad. (Here, we use dollar as a proxy for all other currencies.)
The formula ignores fundamental changes in nature of economies (for instance, increasing services in the mix or digitisation etc.), the relative factor productivity in our economy and those of our trading partners, and the nature and composition of the trade basket itself. These changes are very significant over the long term.
Periodically, we have found it necessary to adjust the external value of the rupee through 15-20 per cent haircut devaluations to align the rupee with underlying economic reality. However, such haircut devaluations do not have a lasting effect. Essentially, the operation of REER, over time, overwhelms the haircut devaluation, bringing the fundamental misalignment back into play soon enough. Like Sisyphus, we are forever rolling the burdensome rock of an overvalued rupee uphill.
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India’s lack of convertible currency
Trade theory, the gift of heroic neo-liberals to an eternally ungrateful mankind, has served the world well since Bretton Woods. What we are about to say will sound like blasphemy, but you must remember that the neo-liberal trade theory was written for nations whose trade, though well-diversified, is largely in balance; with no large or chronic deficits or surpluses, barring short-term fluctuations. (Nations enjoying global hegemony and seigniorage are an exception.)
The theory also assumes that major trading nations have freely convertible currencies that can be lent and borrowed in free markets. With balanced and orderly trade, freely convertible currencies, and deep markets for lending and borrowing currencies, the international trading system creates tremendous value by expanding markets for individual manufacturers across the world while allowing greater specialisation in factor markets. This productivity gain is then parcelled out to consumers across countries.
Within certain, sharply defined limits, such a trading system can also cope with trading nations that lack a convertible currency, or are unable to balance their trade, by creating special financial institutions to lend foreign currencies to them to tide over imbalances. India falls in this category of trading nations that lack a convertible currency and require external funding to finance trade imbalances. Our ability to benefit from international trade is strictly limited by the willingness of others to finance our trade deficits. That is a real constraint that neo-liberals would like us to forget, but which in fact we must never forget. Loans have to be serviced and repaid, unless you enjoy global seigniorage like the US. Or now, perhaps soon to come, China.
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Distinguish earned from borrowed dollars
Let us examine the distinction between dollars earned from exports and those borrowed abroad by way of NRI deposits, loans from global institutions, or sale of equity to foreigners on a repatriable basis, sovereign bonds, etc. Export dollars are earned organically through exports and represent stable commercial relationships and exchanges that continue over time.
Borrowed dollars represent conscious financing decision by the government. They are loans taken out in foreign exchange to finance domestic consumption and investment today, and will have to be repaid in dollars. If these loans simply finance consumption, there is no increase in the future supply of dollars to service these loans. If these finance investment in the economy, then the investment must be such that they increase future exports. Instead, current policies make no effort to track such distinctions and make it easy for the government to live off borrowings without pushing exports. This is our well-guarded secret today, thanks to the masking effect of $400 billion in reserves created out of borrowed dollars.
Hence, we have had zero growth in exports over the last five years without attracting any adverse comment from any regulator. Note that in the early 1980s, the UK had a convertible currency, but because of the chronic balance of payments problems, it had to be dragged to the International Monetary Fund (IMF) and forced to reform its economy.
The distinction between earned and borrowed dollars just cannot be ignored even by developed countries with convertible currencies. In today’s world, where US President Donald Trump’s version of mercantilism rules, this is near-suicidal for a country like India, with a non-convertible currency and a chronic, persistent trade deficit, and an exchange rate that simply doesn’t clear the market even for primary trade transactions.
Take the case of a corporate entity that makes no distinction between revenue from sales and inflow of funds through borrowings. As long as someone is willing to lend without questions, the corporate can easily pretend to have all the cash in the world to do as it pleases. This is exactly what the asset gatherers of the world did in India when there was no Insolvency and Bankruptcy Code (IBC) and loans could be rolled over indefinitely. Like us, the corporate can even pretend it has $400 billion in reserves on its balance sheet even though they are gathered from loans. It may even have expenses greater than revenues and hence be making losses. There are no checks on profligacy or lack of profits. But as soon as incremental lending to fund losses and profligacy stop, the corporate would go belly up and lenders would face massive losses.
The failure to distinguish and discriminate between earned and borrowed dollars in our national accounts has a similar masking effect on reality as in the case of this hypothetical corporate. Worse, as borrowed dollars are fungible with earned dollars, the markets’ natural tendency to depreciate the rupee against dollars to reflect the relative scarcity of dollars is totally defeated. A chronic, persistent and large deficit fails to pressure the dollar upwards, relative to the rupee, resulting in the latter’s overvaluation.
We must find a way to not only identify and segregate borrowed dollars from earned dollars, but also treat them differently in terms of price, in order to mitigate the persistent bias towards an over-valued rupee.
Sonali Ranade tweets @sonaliranade. Sheilja Sharma tweets @ArguingIndian. Views are personal.
One would not lay the blame for our poor export performance and – by extension – our merchandise trade deficit which is now in the range of $ 150 to 200 billion, roughly the value of our oil imports, on an overvalued rupee alone. Most of the worthwhile trade across the developed world consists of manufactured goods. Exports of oil, gas, other, including agricultural, commodities, are important for select countries. India is poorly represented in manufactures because our infrastructure is poor, our power cost is high. Some of our exports like polished gems and jewellery, now also refined petroleum products, how low domestic value added. Our economy is growing steadily less competitive, also less integrated with the world through integrated supply chains. We are averse to joining regional pacts like RCEP. Since college, Zi have never bought this argument that a weak – or weaker – currency would do wonders for our exports. Fortunately, remittances and software – both essentially export of less and more skilled manpower – are keeping the show going.