The strength of the Indian rupee is a hotly debated topic. It is both a source of pride and concern. A robust currency is welcome if economic fundamentals back it up. The current resilience of the Indian currency may be due to capital inflows. Strong capital inflows do not constitute ‘sound economic fundamentals’. What seems to be driving its recent appreciation is how India—as opposed to other emerging economies, including China–is perceived, and less out of an appreciation of its intrinsic strengths. Investors’ perceptions change quickly and often without warning. This perhaps explains why the Reserve Bank of India (RBI) has been intervening and India’s foreign exchange reserves are rising.
To look at the bigger picture, India’s economic growth is middling. It is unbalanced. Private capital formation is still missing. Savings rates have not risen. But, the trade deficit is rising. T.N. Ninan attributes the strength of the Indian rupee to dollar inflows. The solution he had suggested in his column seven months ago was to focus on the source of the dollar surpluses: capital inflows, and debt inflows in particular.
The data does not support his statement. India’s dollar debt and equity flows have not gone up–except in the last few months. Rather, up to December 2016, India’s external debt situation and Net International Investment Position (IIP) have only improved. There were more repayments (outflows) than borrowings (inflows). Only since February this year has India witnessed strong Foreign Portfolio Investment (FPI)–both debt and equity. India’s Foreign Direct Investment (FDI) equity inflows too were strong in the first quarter of 2017 (January to March). Thus, capital inflows into India in recent months suggest that foreign demand for the rupee was high and that the exchange rate responded to this.
The good news is that India is not facing a major competitive disadvantage despite the strong currency because other countries, including China, are not actively seeking to depreciate their currencies. Chief Economic Advisor Arvind Subramanian produced a chart, showing the rising Indian rupee versus the Chinese yuan in his recent VKRV Rao Memorial Lecture. India does have a big bilateral trade deficit with China.
However, focusing on the rupee/Chinese yuan bilateral exchange rate might be a road or bridge to nowhere. Between 2005 and 2015, the rupee depreciated almost 90% against the Chinese yuan on a nominal basis and about 60% on a real effective basis while the bilateral trade deficit went up 24 times from around $2 billion to $48 billion. Currency does matter, but in such cases, global supply chains and productivity differentials seem to matter much more than currency divergence. Productivity is the most important fundamental of all for a strong currency.
The Bank for International Settlements has also written in its 2016 Annual Report on the declining usefulness of exchange rate depreciation for export growth: “Recent studies generally suggest that trade exchange rate elasticities have declined in response to changes in trade structures, including currency denomination, hedging and the increasing importance of global value chains. For instance, a World Bank study finds that manufacturing export exchange rate elasticities almost halved between 1996 and 2012, with almost half this decrease due to the spreading of global supply chains.”
What the BIS is saying is that exports might not be that sensitive to currency weakness or strength as before. Global supply chains matter. However, a strong currency can boost imports. India’s Real Effective Exchange Rate (REER) has appreciated by about 7% to 9% in the last one year, depending on the metric that one chooses, from among the several that the RBI publishes on a monthly basis. REER, however, is adjusted for inflation in India relative to that of other countries (trading partners). Inflation is an indirect measure of productivity. Therefore, REER is productivity-adjusted in that sense. Even so, the rupee has appreciated in the last year or so. That could be why India’s imports are rising faster.
India published its April trade numbers on May 15. The merchandise trade deficit is up sharply. Imports during April 2017 were 49.07% higher in dollar terms and 44.67% higher in rupee terms over the level of imports in April 2016. Excluding the import of crude oil, imports during April 2017 were 54.50% higher than non-oil imports in April 2016 in dollar terms. Exports were higher by nearly 20% compared to a year ago, but the growth in imports outpaced this. Consequently, merchandise trade deficit was 173.5% higher than a year ago in April 2016! 
This should not be surprising for many reasons. One, this is what a strong currency does. It makes imports more attractive. Two, any developing economy that is growing briskly tends to attract more imports. Third, this is also a sign of domestic manufacturing’s relative uncompetitiveness vis-a-vis goods made elsewhere. In general and in rational financial markets, this news should be negative for the Indian rupee. However, it has stayed firm after appreciating in the last several months.
This has not hurt India much so far because crude oil has not sustained its price recovery of last year into 2017. This might persist for quite some time: the risk of a further downside for crude oil price is higher than an upside, which is good news for India. However, if the rupee’s strength persists, then the trade deficit could continue to worsen. That is not good news for India. It would raise the risk of a sudden and significant depreciation in the Indian rupee later.
It is possible to argue that Indian interest rates relative to other countries’ is too high and hence the Indian currency is strong. The Indian interest rate advantage might dissipate if inflation were to rise in the coming months. We have to watch the monsoon and the behaviour of prices after the introduction of the Goods and Services Tax (GST) in July. If inflation remains low even after the introduction of GST, the RBI may have to lower interest rates considerably. Otherwise, the rupee could become overvalued. Overvalued currencies are vulnerable to shifts in investors’ sentiments.
Not too long ago Germany and Japan were able to become export powerhouses despite currency strength. It is true that no country depreciates its way to economic prosperity. In the days of financial globalisation, it is, unfortunately, equally true that no country can appreciate its way to external sustainability.
The situation calls for observation. The traffic light is amber, not red. In sum, it might be dangerous to bask in the strength of the Indian rupee.
Dr. V. Anantha-Nageswaran is Adjunct Senior Fellow, Geoeconomics Studies, at Gateway House.
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