Floating concerns

Indian Express, 12 September 2011

Export data has been showing exceptional growth. Such growth is unlikely to be maintained in the future given the gloomy outlook on the world economy. In 2010 and 2011, if a slowdown in investment was taking place, remarkable exports growth helped to counteract the impact upon demand in the economy. If, in coming months, a reduced pace of investment growth and export growth come together, this would exacerbate the downturn.

High merchandise export growth been a positive feature of the economy in the last year. This growth, rising to above 80 percent year-on-year, in a period when the world economy was in deep crisis seemed rather unbelievable. Some observers questioned the data. There is much to complain about the data, but the gross features of the data do not appear to be wrong.

How did this growth come about? While rigorous answers will only come out in the future, when the full micro datasets are available, a few elements of the story are now visible. One key sector where remarkable growth is visible is engineering. Anecdotal evidence suggests that this has been the consequence of the unprecedented capacity addition, where domestic and foreign companies have been building large-scale plants in India that could only target the export market. When production in these plants started we saw immediate export growth.

This reflects a maturation of India's connections into global production processes in fields such as automobile components. Domestic and foreign firms are increasingly able to plan a role for India in global production chains, and are deliberately setting about building capacity in order to serve long-term production planning. Economists have always emphasised the role of multinationals in trade: It is not possible to achieve high trade integration with the world, without unfettered MNC activity, given that the bulk of world trade today takes place within MNC firms. India is now reaping the fruits of a series of reforms which have made it possible for foreign and domestic MNCs to take root.

Diversification has also taken place geographically. The UAE is emerging as a big export destination. It has replaced the US as the top destination for the export of gems and jewellery from India. Export growth to Asia, Africa and Latin America has improved.

The recent period has been an interesting test case of the role of exchange rate policy. From early 2009 onwards, RBI has stopped trading in the rupee-dollar market. India has achieved the major milestone of economic reform: a floating exchange rate. The exchange rate is the most important price in the economy, and India has graduated to a market determined exchange rate.  In addition, in recent years, RBI has been raising rates in order to fight domestic inflation. High interest rates in India tend to attract foreign capital, which would tend to give rupee appreciation.

The exporter lobby has been hostile to an exchange rate that is set on the market, claiming that exchange rate appreciation is bad for exports growth. Many economists also think that India would do well to emulate China, which tightly manages the exchange rate, and has obtained excellent export growth. If these perspectives were correct, then Indian exports growth would have done badly after 2009. The empirical evidence has gone in the other direction. The floating exchange rate has worked well, with surprisingly high export growth.

A deeper examination shows what was going on. When RBI was buying dollars, in previous years, in order to prevent rupee appreciation, it was flooding the market with rupees. This generated India's inflation crisis, which began in February 2006, reflecting dollar purchases of previous years, and has not subsided since. Another dimension relates to wages: When the rupee appreciates, tradeables become cheaper, which combats inflation. High inflation is bad for the exporter since costs go up. So it is a short-sighted view, to think that manipulation of the currency market by RBI would be good for exporters.

All these fundamental factors will continue to work in India's favour in coming months: Firms in general, and MNCs in particular, will continue to build capacity that is export oriented; India will gain ground in non-traditional products and markets; the exchange rate will float and the government will control the fiscal deficit and RBI will gradually bring inflation under control by raising rates. All these factors yield an optimistic outlook.

The problem lies in the world economy. The key markets of the US, Japan, Europe and the Middle East are all witnessing economic and political problems. While the empirical evidence shows little impact of rupee appreciation upon Indian exports, it shows a strong effect of world GDP growth and world trade growth upon Indian exports. Slow growth of world GDP will surely exert a negative impact upon Indian export growth.

In coming months, we would not be surprised if exports growth slows down. Exporters will then probably start lobbying for RBI to come into the currency market and force rupee depreciation. RBI will need to stay on course. Delivering low and stable inflation is the job of the central bank. Export promotion is not RBI's job. The policy levers through which Indian exports can prosper are: improved infrastructure, reform of labour law, establishment of the GST, removal of the last residual customs duties, financial development, and the removal of capital controls faced by foreign and domestic MNCs. The pursuit of all these long-term projects by policy makers will yield healthy exports growth.

In coming months, if there is a superimposition of slowing exports growth and slowing investment demand, these two could come together to yield a marked deterioration of business cycle conditions. India's potential fiscal crisis is only held at bay by high nominal GDP growth. In a scenario where inflation slows down and real GDP growth slows down, the fiscal crisis will rapidly flare up. This could yield rough weather in the macroeconomy in the remaining 2.5 years to the general elections. This could thus shape up as a difficult time.

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