In the last few months there was a huge depreciation in the rupee vis-a-vis the US dollar. The rupee-dollar exchange rate, about `65 in April, hit a low of `74.48 on October 11. However, the rupee strengthened to `69.85 per dollar by November 29. On the one hand, there was an atmosphere of concern in the country, due to the rupee’s weakening; many eminent people associated with policymaking were saying the fall was natural as the rupee is already stronger than what it should be.
They were not hesitant to say that the weakening was in the nation’s interest, because it helped exports to grow. But the experts had differing views about how much it should depreciate. The vice chairman of NITI Aayog said in July that it was 5 to 7 per cent overvalued, while other experts were saying it was overvalued by 10-15 per cent. This was not the first time these policymakers were advocating that the rupee was overvalued and were advising to weaken the same.
The rupee’s weakening in the last six months has been due to many reasons, but they were generally temporary in nature. The first reason was the steep hike in global crude oil prices. India imports over 70 per cent of its petroleum requirements. Except to Iran, we have to pay in dollars for imports of crude from all other oil exporting countries.
Another major reason for the weakening was that foreign institutional investors (FIIs) started withdrawing their investments from India. In recent months, they sold heavily in equity and bond markets. So the demand for dollars increased, putting pressure on the rupee. Though there is no conclusive evidence about the same, the third reason was said to be the scaling down of personal and corporate tax by the US government and increase in rate of interest by the Federal Reserve (the US central bank). It was said investors started finding the US a more remunerative destination.
If history is any guide, the prices of crude oil in the global market are not always rising. An increase in crude prices generally happens due to limiting of supply by the Organization of Petroleum Exporting Countries (OPEC). But with increase in supply in international markets, the prices of oil again start falling.
The same happened recently and crude prices declined in international markets to less than $60 per barrel. It’s notable that a fall of $1 a barrel in the price of crude can reduce our annual oil bill by $1.5 billion. Thus, the fall of $26-27 in the last one month can reduce our oil bill by over $40 billion annually. The FIIs have also started turning towards India once again. The rise in the stock market over the last couple of weeks has been indicative of the same. So, the demand for dollars has started coming down and the rupee is naturally getting stronger.
The most disappointing thing is that when the rupee was getting weak due to temporary reasons, the RBI failed to discharge its responsibility of stemming the weakening due to sudden but temporary reasons. Even more unfortunate is that many experts responsible for the government’s economic policy decision-making have been arguing that the rupee needs a downward correction.
While it was clear that depreciation has been primarily due to short-term developments, and not due to any fundamental weakness in India’s economy, they were still making arguments based on the unreasonable logic of Real Effective Exchange Rate (REER). Theoretically, REER is an indicator of the competitiveness of a nation’s currency with respect to a basket of currencies, adjusted for inflation effects. Economists believe the theory based on REER does not give an exact solution to what should be the exchange rate, as its concept of exchange rate determination suffers from many biases and axiomatic shortcomings.
When we look at India’s economy we find that the rate of GDP growth is increasing and rate of inflation is continuously declining. Thanks to various policy reforms, ‘Ease of Doing Business’ too is improving and there is a steady increase in agricultural and industrial production. Under such circumstances the advocacy of rupee depreciation seems not only illogical, but also irresponsible.
They send wrong signals to the markets, and may disturb the natural market mechanism in determining the exchange rates. Further, the sequence of events in the last two weeks nullify their arguments that the rupee is overvalued. Again it is notable that over the factor on the basis of which many have been advocating a depreciation of the rupee, namely, REER, there is no consensus among economists. In fact this factor does not apply in India.
In the last few decades, due to the opening up of imports in the name of free trade, especially after signing of WTO agreements, we have continuously increased imports at a fast pace. Exports have not kept pace with imports; our trade deficit and balance of payment deficit have been increasing in leaps and bounds.
The reality is our policymakers chose to impose much lower tariffs than what was permissible under WTO agreements. We can increase our tariffs by two to four times while remaining WTO compliant, and reduce our imports and thereby promote our domestic industry. This can prove to be an important step towards strengthening the rupee. It is notable that an improvement in exchange rate by one rupee vis-a-vis dollar saves nearly `12,000 in the import bill. So, it would be a prudent policy to strengthen the rupee. We should not forget that the RBI too has the responsibility of maintaining the stability in the exchange rate due to short-term disturbances like hike in crude prices or withdrawal by FIIs.