No quick fix solution

As the rupee continues its unrelenting southward journey, it is time to examine the central question: Is this an unmitigated disaster for the economy, as is being projected in the media?

The truth is that some people will gain and some will lose as a result of the depreciating rupee. Broadly speaking, exporters will benefit as their exports will become cheaper abroad (in dollars or euros) which means greater demand for their export products, such as for Indian tea or garments (for example).  Also, the rupee realisation from the dollar earnings will be more. Thus, (for example) the major Indian software and pharma companies would gain as the prices of their goods and services are usually fixed in dollars. Foreigners coming to India for tourism or medical treatment would be better off. So would be the NRIs sending remittances. 

The rupee cost of imports -- like petro products, coal, fertiliser, edible oil -- would go up, fueling a hike in the already high inflation rate. The prices of many consumer durables (like cars, computers, air-conditioners, TVs, digital cameras, mobile phones) that have direct or indirect import content would also rise. The consolidated fiscal deficit of the government would go up to the extent it is not able to pass on the rise in cost to final consumers of petrol, diesel, kerosene, LPG, electricity and fertilisers.

The higher is the net import content, the larger would be adverse impact. For instance, the  low-cost domestic airlines (like Indigo) would be more adversely affected, relative to airlines like Jet Airways which have foreign operations and earn dollars from foreign passengers. By the same token, the net impact on gems and jewellery sector which uses a lot of imported materials would be small, relative to software companies with low import content. 

Importers who have already hedged against exchange rate fluctuations (through forward market cover) would be less adversely affected than those with no risk hedging. On the other hand, exporters who had hedged and sold their export earnings in the forward market at, say, Rs 56 to a dollar are suffering a (notional) loss as they are not able to take advantage of the much higher current price of dollar (say, Rs 66 for a dollar). Thus, unhedged exporters are gaining more. In the rather stagnant domestic market, firms like car companies may not be able to pass on the full cost of higher imported materials to the buyers and may have to take a hit on their margins. Firms that have raised foreign funds would see a rise in their debt servicing cost in rupees, affecting their bottom lines.
Banks that have lent to companies and traders with squeezed margins would suffer a decline in their asset quality and a rise in NPAs. With worsening balance sheets, such banks would be forced to lend less and/or raise the interest rate on loans.

Adjustment process

Some economists (including our economist prime minister) view the depreciation of rupee as part of a long-due adjustment process needed to restore the international competitiveness of Indian goods and services which, they hope, will eventually take care of our growing balance of payments (BOP) problem. The question is: Is it going to be sufficiently effective in the current situation?

Several points need to be noted in this connection. One, currencies in some other emerging economies (like Brazil, South Africa, Indonesia) are also falling a lot relative to US dollar. Therefore, the gain in international price competitiveness of Indian goods, relative to such countries, is not much. However, if countries like China, Bangladesh Vietnam, Thailand and Kenya are considered our major competitors (in goods like tea, textiles and jewellery), then we should get a significant competitive advantage, provided those countries do not engage in competitive devaluation or matching price cuts.

Second, the effects of depreciation take time to work out. Exporters and importers are bound by existing contracts and need time to change trading partners. Importers care about reliable quality, maintenance of delivery schedules, brand images and credit terms, in addition to price, while deciding to buy. 

Third, if there are supply constraints (like in many agricultural products, minerals), then the higher foreign demand -- due to lower price in dollar brought about by the falling rupee -- would cause a rise in the domestic rupee price of the export commodities. The initial gain in price competitiveness brought about by depreciation would be largely offset by subsequent higher inflation. Thus, removing supply bottlenecks is crucial.

Fourth, the net capital inflow into India would depend on a host of factors other than an attractive exchange rate —  like the expected future growth of  GDP and  the consequent profitability of investment, the risk-adjusted  difference in interest rates at home and abroad,  the international credit rating of the country (many FIIs are mandated to reduce  a country’s weightage in their investment portfolio if  credit rating drops) and  the state of infrastructure and governance determining the overall ‘investment climate’.

Finally, so long as traders and investors (including NRIs) believe that the rupee has not yet stabilised and may fall further, they would postpone bringing in their dollars while importers and speculators would rush to buy dollars, aggravating the demand-supply gap in the foreign exchange market. The market does not exactly know what the ‘fair’ value of rupee is, specially when the depreciation itself increases the inflation rate, sowing seeds for further depreciation.  The so-called ‘intrinsic value of rupee’ has to be discovered over time through trial and error, causing a lot of exchange rate volatility in the interim, as a result of speculative activity. Consequently, it would be naive to expect a quick fix to our balance of payments  problem through the ‘automatic’ adjustment  mechanism of a floating exchange rate.

(The writer is a former professor of economics at IIM, Calcutta)