Surgery for PM, band-aid for the economy?

The 26/11 terrorist attacks made us forget the economic recession. Satyam helped us forget these attacks. Now the setback to PM's health has helped us forget Satyam. Before another crisis intervenes, let me take a quick look at the Indian economy that is fast spiraling into an unprecedented slowdown.

This slowdown needs to be seen in the context of the government having prescribed two (stimulus?) packages to revive the economy and RBI repeatedly easing monetary policies. While sections of media, industry and analysts termed these as the perfect aphrodisiac for the economy, reports emanating from the ground level tell us a different story altogether.

Like the PM, the economy too seems to suffer from multiple blockages. And unlike the by-pass surgery to the PM, these packages seem to have bypassed the national economy! In effect, these packages seem to be a by-product of poor diagnosis. By extension, instead of carrying out a comprehensive surgery, our economic managers seem to have prescribed band-aid to the economy.

And one of the blockages to the national economy has been caused by our poor exchange rate management of the rupee over the past two years. Exchange rate management, in the context of a liberalised economy calls for dexterous and transparent management of the rupee. We lack both in our exchange rate management.

It may be noted that large capital inflows and equally large outflows could well dynamite the exchange rate movement of a currency. The experiences of the past two years clearly indicate the fact that sudden surge of capital inflows lead to a sharp appreciation of the rupee in 2007 while the abrupt outflows lead to a steep depreciation of the rupee in 2008.

The sudden appreciation resulted in a loss of India's international competitiveness; the sharp depreciation of the currency has proved to be extremely 'dislocative' to the economy. A developing economy can hardly afford such volatility of its currency.

How a gyrating rupee affects India

Readers may well recall that China pegged its yuan at 8.28 to the US dollar for well over a decade since 1994 till 2005. It is no coincidence that as the exchange rate of yuan was cast in stone, China experienced spectacular growth of its economy. Given this paradigm of a stable yuan, its concept of SEZ and an export driven macroeconomic model made real sense.

The Indian experience is a study in contrast. Illustratively, Indian exporters had hedged their receivables at the prevailing rates in 2007-08, premised on the assumption that rupee could appreciate further. But when the rupee depreciated, many exporters were caught in the wrong foot, leading to excessive losses (both notional as well as actual) on this count.

This sudden gyration of the rupee was on account of an inexplicable yet sudden strengthening of USD at global level since March 2008. Even global analysts could not anticipate this sudden change in value of the rupee (and USD). Therefore, to expect ordinary exporters of the country to take appropriate corrective steps in anticipation of the exchange rate movements is a joke if not a cruel one.

The collateral damage of a gyrating rupee is so huge that export centers like Tiruppur, Karur and Ambur in Tamil Nadu are virtually on the verge of closure. Lakhs are losing their jobs as units after units face closure. I am sure that exporters from other parts of the country are facing similar problems as are importers on account of a volatile rupee.

Needed a policy on exchange rate management

All these are having a significant bearing on the national economy in these grim times. It is in this context the Confederation of Indian Industry has recently suggested that the rupee should be pegged at Rs 45 to dollar in the "greater interests of the economy." While such an approach can definitely be explored, the truth of the matter is that exchange rate cannot be determined (and pegged) in such a simplistic manner in these complex times.

Therefore, we need to fall back to a more predictable and reliable exchange rate mechanism rather than one that encourages volatility or a fixed exchange rate system that allows build-up of pressure points (inflation for instance) in other sectors of the economy.

It may be noted that the Indian exchange rate regime is classified by the International Monetary Fund as a "managed float with no predetermined path for the exchange rate". Certain exchange rate managers have argued that our exchange rate policy must centre on managing volatility and not on pegging it. This is in my considered view is the Indian route to exchange rate nirvana.

It can be noted that RBI announces the movement in its exchange rate through a process of computing the Real Effective Exchange Rate. This is the weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries, drawing upon the purchasing power parity hypothesis.

While this may be complex economics for the common man, simply put, the exchange rate of the Rupee is based on a 6-country index comprising (i) the share in India's exports and trade, (ii) regional representation and (iii) the availability of data on exchange rate and prices on a monthly basis.

The 6-currency index includes the US, Euro, UK, Japan, China and Hong Kong. The index uses the wholesale price index as a proxy for Indian prices and the consumer price index as a proxy for foreign partner countries and uses these factors to curb excessive exchange rate movement of the rupee.

Unfortunately, REER does not have a policy status right now apart from being a theoretical reference point for researchers. Nevertheless, many policy framers and economists have suggested that the exchange rate management of the rupee must centre through the REER.

In fact, the 1997 Tarapore Committee constituted for suggesting a road map for full capital account convertibility had recommended using REER for exchange rate management. The Committee then recommended: "The RBI should have a Monitoring Exchange Rate Band of +/- 5.0 per cent around the neutral REER. The RBI should ordinarily intervene as and when the REER is outside the band. The RBI should ordinarily not intervene when the REER is within the band. The RBI could, however, use its judgment to intervene even within the band to obviate speculative forces and unwarranted volatility."

The subsequent Tarapore Committee formed in 2007 and revisiting the same subject stressed in finality that the REER should also be a valuable input into the formulation of the RBI's exchange rate policy and fully endorsed the recommendations of the 1997 Committee.

It may be noted that the rupee has been well outside this suggested band since early 2007. While it is easy to blame global recession for the slump in our manufacturing, the debilitating impact of the poor exchange rate management is too obvious to be missed by our policy framers. India is still unprepared for its financial sector liberalization to power the real sector. The tail cannot wag the dog, at-least in the Indian context.

Solution may well be outside India

Another reason why Indian exporters have been left globally uncompetitive is primarily because of the undervalued Chinese yuan. Our policy framers have been somehow been negligent to this issue of China manipulating its currency.

While the issue engaged the attention of economists till a couple of years ago, the mild appreciation of yuan since then seems to have lulled many into a false sense of complacency. Some economists, notably in US, believe that China has to revalue its currency significantly. Naturally, the value of the Yuan is central to any discussion on global trade.

Yet we somehow innocently believe that our competitiveness is centered on our ability and our exchange rate management only. Little do we realise that in a globalised world, what equally matters is the competitiveness of our peers. Strangely, Indian industry as well policy framers have been maintaining an inexplicable silence on this crucial yet sensitive matter.

It is in this context the latest comment by the incoming treasury secretary Tim Geithner has set the cat amongst the pigeon. In a written response to questions to the US senate debating his confirmation, Geithner accused China of "manipulating" its currency and promised that the new US administration would push "aggressively" for Beijing to change its policies.

The use of the "M" word immediately set the financial markets on fire. While US policy framers have often accused China of currency undervaluation, the Bush administration was reluctant to act. Geithner's approach perhaps is indicative of the tectonic shift in the US approach to the vexed issue by the new Obama administration.

This does provide opportunity to the Indian industry, especially exporters, to join hands with the US administration to ensure a phased revaluation of the yuan. A strong yuan would imply costlier exports from China. That would in more ways than one make Indian exports competitive. Isn't it time for our industry to encash the goodwill created by lobbying for the nuclear deal?

All these call for enormous coordination between the two nations, governments and industry. Unfortunately, even the best of our trade bodies and chambers of commerce still believes in crass lobbying and playing a role of a supplicant rather than leverage on evolving global situation and develop appropriate strategies. And till such time Indian industry realises all these it would be condemned to get its usual ration of band-aid from our government.

The author is a Chennai-based Chartered Accountant. Comments can be made at mrv@mrv.net.in