The failure to distinguish between dollars earned from export and those borrowed leads to a situation where the two become fungible, as we outlined in the first part of our series. This failure artificially boosts the supply of available dollars in the market, preventing the price of dollar from climbing to a level that would naturally balance imports with exports, thus clearing the market. This, in turn, makes the Indian rupee chronically overvalued, inhibiting exports while encouraging imports, thus perpetuating the chronic trade deficit instead of eliminating it.
So, we need to restructure our foreign exchange market in a way that the exchange rate plays its proper market-driven role in encouraging exports, moderating imports, and over time, bringing the trade deficit back in balance.
Reserve dollar and auction
Segregating export-earned dollars from the borrowed dollars on the capital account is not very difficult. The rupee is not convertible on the capital account, where almost all transactions invariably pass through the books of the Reserve Bank of India (RBI). NRI deposits with banks, FPI inflows/outflows from FIIs, FDI, corporate borrowings abroad by private and public corporations, subscription to government masala bonds, and sovereign borrowings etc involve the RBI as a key player and an intermediary in the transaction. Similarly, all repayments and outflows on capital account involve the RBI’s intermediation and authorisations. So, segregating, tracking and controlling transactions on the capital account is not difficult for the RBI. Trade transactions, on the other hand, don’t require such tracking and can continue as usual.
The cardinal principle in managing the external value of the rupee must be to let the supply of dollars earned from exports balance out the dollars needed for imports in the day-to-day spot exchange market. To this end, every dollar inflow on the capital account must be impounded into a separate dollar account and fully sanitised. The RBI would not create rupee in the domestic market corresponding to these dollars immediately on receipt. These dollars inflows would instead be held in reserves to be made available to the foreign exchange market through weekly auctions for such dollars in which banks and other large importers could be allowed to participate.
Assume the projected primary trade deficit is 3 per cent of the GDP and the government proposes to borrow another 2 per cent of the GDP abroad for meeting the shortfall in domestic savings in a given year. Thus, the total dollar inflows in the year would be about 5 per cent of the GDP. The RBI should then aim to auction about 5/52 per cent of the GDP of the projected inflow of dollars through a weekly auction in which authorised dealers/banks and large importers like oil marketing companies (OMCs) could participate. So, all importers, together with those who need to remit dollars out, including that on capital account by way of repayments etc, would have to buy their dollars in the regular foreign exchange market. The shortfall in supply, if any, would be met through weekly auctions. The RBI would have the option to set an undisclosed reserve price in such auctions. If the reserve price is not met, the auction would be cancelled. Participants, on the other hand, would not only have to bid for a certain quantity at a certain bid price, but also take full delivery of dollars at the bid price.
Over time, the daily spot price of the dollar would converge towards a price that takes the higher auction prices into account, and, barring surprises, the difference between spot and auction prices would be minimal. However, there would be a quantum change in the overall price behaviour of the dollar in the market.
Anomalous price behaviour of dollar in spot markets
The current market for dollars is characterised by sharp spikes in the value of the dollar in times of crises or when the RBI itself resets the value of the dollar following an explicit or implicit devaluation. Thereafter, the spike is mitigated by a downward sloping price graph, though not fully, to yield the familiar Real Effective Exchange Rate (REER) determined 2 to 3 per cent depreciation per annum on a net basis. This falling price of the dollar after a spike favours the importers, and works to the detriment of the exporters. The downward trend can last a year or more, throwing planning for exports out of kilter. What the weekly auctions will do instead, is to administer this multi-year spike in the price of the dollar, in small doses on a weekly basis, eliminating disruptive haircut adjustments. Moreover, the price of the dollar on a day-to-day basis would gently slope upwards most of the time, with corrections in the price on the downside being sudden and short-lived. In other words, the price trend would then favour exporters most of the time, which is what policy should aim for.
However, by far the biggest advantage of this system over periodic, but discretionary, interventions by the RBI in exchange markets is that the price discovered in auctions would be closer to what the market thinks is realistic, and would be set regularly in a transparent fashion. The opaqueness that characterises the current system would be mitigated. And it would neatly segregate earned dollars from borrowed dollars, letting earned dollars gain in value in line with their scarcity value. This would go a long way in encouraging the growth of exports over the current price-setting system for dollars.
Setting the dollar’s rate right
We need to enhance the profitability of exports relative to imports in order to encourage exporters. The perverse system right now does the opposite most of the time. Second, we need to distinguish between earned dollars and borrowed dollars in a transparent fashion until we have a convertible rupee and the dollars available from exports at least cover imports. This is all the more imperative in the new trading system where automatic financing of trade deficits is not guaranteed, and there is no lender of the sort that doesn’t go through US President Donald Trump. We also have to make sure that the mechanism for price discovery for the dollar is transparent, market-driven, and verifiably so, in order to forestall increasing pressures from the US over currency manipulation. The US has already designated China as a currency manipulator. India was second on its list of potential currency manipulators.
Much of what we want to do in terms of labour reforms, achieving competitive wages in dollars, protecting nascent domestic industry, and managing trade with China and the US, can be done through setting a realistic rate for the dollar, which is discovered through a market-driven auctions rather than assuming the exchange was correctly aligned in the base year of 1993 and mechanically assuming that inflation differentials account for the rest.
Achieving a market-driven realistic exchange rate mechanism for the dollar was one of the key policy goals of the 1990-91 economic reforms in India that sparked the revolution in the country’s exports. However, the mechanical application of REER thereafter negated much of that advantage over time, and growth in export has fallen back to nearly zero. REER has been in operation since 1993 and is over 25 years old, a period in which the world economy has undergone a sea change. As such, the working of the mechanism warrants an in-depth review.
Exports are the touchstone for a competitive economy, and their sluggishness is the sharpest indicator that we lack competitiveness in international markets. Exchange rates by themselves will not create competitive enterprises. They have to be created the old-fashioned way by hard work. But without an enabling exchange rate mechanism, such enterprises will never be created at all.
We need to completely overhaul the way we look at growth, competitiveness and exports. Our smaller neighbours are already outpacing us. We can no longer claim fictitious exceptionalism.
This is the second article in the two-part series on India’s trade deficit. Read the first part here.