India's currency dilemma - a stronger or weaker rupee?

Recent yuan devaluation has generated lots of controversies ranging from currency war to growing divergence between Chinese and US economies to what will happen to Indian rupee. Should RBI let rupee depreciate by rate cut  or should it raise interest rate to defend rupee? What will happen to corporate profitability if rupee goes down or goes up? That leaves us with the question: what is better for India - a weaker rupee or stronger rupee? The answer lies in understanding how the rupee exchange rate is going to impact export, external debt management import and inflation management. 

Exports

Over the years, India's export basket has undergone serious transformation. India now exports more of income elastic goods (e.g. chemicals, engineering goods and refined petroleum products) and less of traditional price elastic goods (textile, apparel and leather). Thus, a much higher depreciation of rupee would be needed to boost India’s exports when global growth prospect is bleak. Moreover, importers start asking for discount if rupee weakens that cuts into exporter's margins. Further, increasing fragmentation of production process across different countries has made exchange rate less relevant for trade.

Besides, services now are more important in India's overall exports that again are more dependent upon growth prospects in developed markets than rupee exchange rate, though weaker rupee does help India’s IT services providers in offering lower prices to their clients. To conclude, the case for promoting exports through weaker rupee is not very strong. Besides, it may not work as each country is trying the currency devaluation route to capture an increasing share of sluggish global demand. Global boom is more likely to lift India's exports than rupee exchange rate as past experience shows. #Rupee#

Cost of external debt management

With growing integration of Indian financial sector with global financial system, better rated Indian corporates are increasingly going for cheaper foreign currency loans. Latest RBI data shows that external commercial borrowings from March 2014 to March 2015 increased by 32% to $181.9 billion. This is 38% of India’s total outstanding external debt. The hedging ratio (as per RBI) was 41%. Thus more than half of forex exposure of Indian companies remain open and that increases #currency risk#.

Most of the sales however are contracted in rupee. Weakening rupee increases the rupee cost of their overseas commercial liabilities. That, in combination with slowing demand adversely affects their profitability and in turn their ability for future capital expansion and job creation. To cut the long story short, stronger rupee helps corporates with un-hedged forex loans which is the reality because hedging actually costs, and that erodes any benefit of taking loan in forex currencies.    

Imports

Both, India as a country and India Inc. as a whole are net importers. Thus a stronger rupee will keep the cost of imports - crude and edible oil, capital goods, precious metals, electronics and consumer appliances - lower. Stronger rupee also helps in keeping fuel and fertilizer subsidy bills under check that is needed for meeting the country’s fiscal targets. 

Critics argue that stronger rupee hurts MSMEs (which source their raw material domestically but export most of their finished products overseas), and hence keeping rupee stronger is nothing but anti-poor. Really?

With import duties being no longer as high as they used to be in pre-reform era and trade logistics cost going down each passing day because of slowing global trade and crashed crude prices, import parity pricing of inputs is the prevalent norm. Thus whether you use imported inputs or not, your input cost will be determined by what would be the cost of their imported substitutes. Thus, a stronger rupee helps in minimizing the cost of production of any manufacturer - small or big.

If you import your inputs and export your finished products you are naturally hedged irrespective of rupee exchange rate. One can still argue that stronger rupee makes exports expensive to importers and thus hurts them. That’s right logic but is not so relevant because our export basket is now more income elastic than price elastic as discussed above. Well, what if you source your raw material domestically and also sell your produce in domestic market. Even then a stronger rupee will ensure that your raw material cost don’t go haywire though you may have to compete with relatively cheaper imported goods.

Inflation management

A weaker rupee means rupee has lower purchasing power that further goes down if inflation goes up in an inflation prone macro-economic environment like ours. Inflation is no doubt more anti-poor than it is anti-rich. It reduces the real purchasing power of poor the most, and encourages income and standard of living inequality. Stronger rupee by making imported goods cheaper keep a tab on the activities of hoarders and black marketers of essential items that is more important for poor than for the rich.

Given the poor state of higher education or unavailability of seats in quality educational institutions, those who can afford are sending their children abroad. Weaker rupee, thus will penalize the middle class as well.    

 So what the RBI should do - let rupee sink or raise interest rate to defend it? It should use interest rate to defend rupee especially when US fed rate hike is imminent. Stronger rupee will at least help India in keeping import bills under control when exports are not showing any sign of recovery despite the fact that rupee is quite low at 65 to a dollar. That partly may be because of competitive devaluation of the currencies of India's export competitors. Stronger rupee will affect exports negatively for sure though not as much as we think. 

However, one must remember that rupee exchange rate is not going to affect all sectors of the economy equally even if they are all net importing sectors. Gain from exchange vary depending upon time of contract and hedging strategies of the specific firms.

Plus, India's exports are suffering from several non-currency internal and external factors that need to be tackled on urgent basis such as poor trade facilitation regime and increasing trade barriers erected by importing countries. The latest example is EU banning sale of 700 generic medicines tested by GVK Bioscience. Problems like this can’t be tackled by exchange rate management.

I rest my case for a stronger rupee. A slightly modified version of this post has been published by Business Line Newspaper: a stronger rupee makes sense now, August 25, 2015. Please share your thoughts even if you differ from me. if we're not connected, it's time we got connected. Another interesting read on the subject: why the rupee slide isn't helping the tech firms?

Why India gets foreign borrowing wrong

If you like this post, please share it with your colleagues and friends who may like to check it. You can follow me on twitter @RiteshEconomist and The Smart Consumer

Please share your ideas and thoughts on the subject. Humans should differ because we're all unique in our own ways and hence, are expected to think differently. It doesn't matter even if you have a different viewpoint. Please feel free to criticize my ideas...but please give your reasons for the same. That will help me improve my knowledge and understanding. If we're not connected, it's time to get to know each other.