Unbridled imports and living beyond our means
The rupee appears to have settled at 55 for a US dollar, closer to 56 in fact – at least for now. This represents a fall of over 20 per cent in less than a year.
The exchange rate has been in the headlines for some time now and there is greater awareness of the consequences of a weak rupee for the Indian economy with its deficits in the current and trade accounts.
In effect, these deficits are a measure of the excess that India pays others for imports than the value it receives for export of goods and services.
Faced with the decline in the rupee’s value, the policy makers in New Delhi have responded predictably – with efforts to boost foreign inflows. Encouraging foreign inflows has been the mantra in New Delhi since 1991 when the government opted for the globalisation model of growth.
Recent measures taken by the government in response to the falling value of the rupee include encouraging Indian companies to borrow from abroad and allowing individual foreign investors to invest in the Indian stock market. With falling rupee and burgeoning liability, it is not clear how many companies will be keen to take on more foreign debt.
Boosting capital inflows, as a stand alone policy, raises a number of issues. It overlooks the fact that exchange rates determined in the financial markets are a product of numerous factors. Among them, supply of dollars is only one; this is what New Delhi focuses on. Two other key factors are (a) the trade regime and large imports that generate deficits, and (b) fiscal and monetary policies that determine the quantum of rupees circulating in the market.
These two elements do not apparently receive much attention from the policymakers in their efforts to manage the rupee’s value. This article explores some implications of trade policies on the rupee’s exchange rate.
India has had deficits in its current and trade accounts for most of the last six-plus decades since independence. These deficits create a large demand for US dollars to pay the import bills, leading to demand pressures on the rupee’s value. Demand for dollars has the natural result of driving up their value and weakening the rupee.
Until early 1990s, exchange rates were determined by the government in consultation with the International Monetary Fund (IMF), under the Bretton Woods arrangement crafted in the 1940s. The liberalized exchange rate regime that currently prevails was introduced in the early 1990s, as a part of India’s transition to making its place in the globalising economy.
The trade and current account deficits generate significant supply-demand dynamics which impact the exchange value of the rupee. A possible approach in this direction is to calibrate India’s trade policy and prioritise or rationalise imports – in other words, a less liberal import regime.
This can help India determine better whether it should continue to import non-essentials such as gold and consumer goods. India was able to do this during the 1990s and the 2000s due to a favourable international climate and expanding liquidity that fed India’s demand for US dollars. And the government did not apparently care that the current account and trade deficits were funded by capital inflows. In simple terms, it was like a family selling capital assets, or worse borrowing money, to finance its living expenses.