Since January 2018 the Indian Rupee (INR) has depreciated almost 6% against the US Dollar. Over the last seven years, the INR has depreciated 35% against the USD in nominal terms.
The Rupee is now grossly undervalued and this has serious repercussions for the country’s growth. A weak Rupee makes imports more expensive, and if oil prices go up another 10%, as predicted, India’s oil imports will produce substantial inflation and act as significant damper on already reduced growth prospects.
It is time for the Reserve Bank of India (RBI) to examine its Rupee policy and make the INR a fully convertible currency. Currently, the INR has free current account convertibility but not full capital account convertibility. As a result, foreign investors cannot freely invest in India’s capital assets ( stocks, bonds, real estate, startups etc.) and Indian companies cannot freely acquire foreign assets. This inhibits the flow of foreign investment into India and is a deterrent to growth in a country that is in dire need of investment capital.
Restrictions on the free flow of capital add a substantial risk premium to the INR exchange rate. Currency controls may have been justified in the past to prevent the flight of capital when India had low Foreign Exchange Reserves. But now the country has over $ 400 billion in Reserves, and it is imperative that the RBI remove all controls and make the INR a fully and freely convertible currency. The ability to freely buy and sell assets will improve the confidence of foreign investors and enhance the flow of external capital into the country. Also, the full convertibility of the rupee provides greater flexibility for Indian companies to take advantage of the investment opportunities and lower borrowing rates in overseas markets.
A weak rupee is a key reason why India’s economic growth is stuck around the 6.5% mark. A strong currency allowed Singapore’s founding leader Lee Kuan Yew to build that country from a dry, barren land into a financial powerhouse in less than forty years. In a Wall Street Journal interview, he said it was his adherence to keeping the Singapore dollar strong that kept inflation low and allowed the government to build the infrastructure and institutions it needed to grow the economy.
Indian policymakers, on the other hand, have always advocated for a weaker INR in the hope that it will boost exports and help to promote Indian manufacturing. While it is true that a weaker currency reduces the price of exports, the composition of India’s exports makes it difficult for a weaker Rupee to have a significant impact on the total value of the country’s exports. Almost 26% of the exports are value-added petroleum products which actually get more expensive as the INR depreciates and the price of imported crude oil increases. Another 35% are gems and jewellery, and pharmaceutical products and India has a significant comparative advantage in those goods and it is unlikely that a stronger INR will adversely impact these exports.
But, a weaker INR makes imports more expensive and is inflationary. With oil constituting almost 66% of total imports a weak Rupee adds almost 2% to India’s inflation according to the government’s Economic Survey. The combined effect of a weakening INR and an expected rise in crude oil prices to $80a barrel will have a substantial negative impact on India’s inflation and GDP growth. On the other hand, a ten percent appreciation in the INR would save almost $ 16 billion in oil imports, and significantly reduce inflation which will allow the RBI to lower interest rates. India also needs a massive infusion of capital equipment and high-value technology to enable its manufacturing sector to produce goods that the world wants. A stronger rupee will make it cheaper to import the technology required to develop a robust manufacturing sector.
What is the fair exchange rate for the INR? Several factors affect exchange rates, but relative rates of inflation and interest rates play a significant role. According to the Purchasing Power Parity (PPP) theory, the correct exchange rate is one that makes the price of an identical product ( or a basket of products) equal in both countries. To test purchasing parity, The Economist puts out an annual index that measures the price of a McDonald’s Big Mac in different countries. In January 2018, a Big Mac in the US was $5.28 and in India Rs.180. This suggests that the implied exchange rate that makes the price of the Big Mac equal in the two countries is Rs.34.09 per US Dollar. While the Big Mac index is a little tongue-in-cheek and deceptive because of differences in ingredients and the size of Big Macs in different countries, it does suggest that the INR is one of the most undervalued currencies.
Take another example to illustrate this undervaluation. India’s nominal GDP in 2017 was $ 2.31 trillion, but in Purchasing Power Parity (PPP) terms it was $ 9.44 trillion. This suggests that Rs.65 in India purchases almost four times more than $ 1 in the US, indicating that in real terms the rupee is significantly undervalued.
Keeping the exchange rate low is useful for jump-starting growth but once growth has become sustained the case for keeping exchange rates low is weak. On the contrary, a stronger currency may be more beneficial for a country like India where growth comes from strong internal demand and not exports. China is a poster boy for low-exchange rate export-led growth, but its growth came at a substantial cost. It massively subsidized its manufacturing sector, especially in its port cities, but this led to to the exclusion of its service sector and inequality among the different regions of China.
Over the years India has made it attractive for overseas investors to invest in India by liberalizing Foreign Direct Investment (FDI) in most sectors. But the total capital investment by foreigners in India is still minuscule relative to the size of the opportunity. This is because returns don’t match the risks of investing in India. And a depreciating Rupee makes realized returns for foreign investors even smaller.
It is time for the policymakers and the RBI to make the INR a fully convertible currency and allow the currency to appreciate to its fair value. A stronger Rupee will reduce inflation and put downward pressure on interest rates and make borrowing more attractive for Indian companies both domestically and overseas. A stronger currency will also lower the cost of importing high-technology capital equipment and make India an attractive destination for foreign investors by increasing realized returns.