India's exports grew by 37.5 per cent in 2010-11. It is true that the year before saw negative growth in exports on account of the global financial crisis. As such, the base effect had its impact in inflating the export growth number. However, even after accounting for the base effect, export growth is estimated at around 30 per cent in 2010-11.
The surge in exports helped contain the current account deficit (CAD) to around 2.5 per cent of GDP. The high growth in exports helped not only in surpassing the target of $200 billion for 2010-11, but also motivated the Government to upwardly revise the target for 2013-14 to $500 billion, from $450 billion agreed upon a few months back.
The Real Effective Exchange Rate (REER) indices for six-currency, 30-currency and 36 currency baskets exhibited appreciation of the rupee during 2010-11. The domestic interest rates also were at elevated levels due to the shortage of liquidity and the hike in policy rates (in order to control inflation) on seven occasions in 2010-11, amounting to a cumulative increase of 175 basis points.
Against the grain
The popular perception is that rising interest rates and an appreciation of the REER hurt exports. How come the standard arguments did not hold?
First, it was case of a rising tide lifting all boats. The growth in global output and merchandise trade volumes did help growth in exports. While output rebounded for the world economy to 5 per cent from a negative 0.8 per cent, trade volumes grew by 14.5 per cent in 2010 from a negative 12 per cent in 2009.
Second, diversification of the export basket and across destinations helped the stellar growth in exports. Exports have seen a shift away from the US and EU to West Asia, Asia and other emerging markets.
Third, Nominal Effective Exchange Rate (NEER) appreciation has been much less than REER appreciation (Table).
REER appreciation was maximum for the six-currency index, reflecting higher inflation differential with countries such as the US, the Eurozone (comprising 12 countries), the UK, Japan, China and Hong Kong that constitute the index.
While China is often accused for keeping an artificially undervalued exchange rate to help its exports, one wonders what has prompted India with a much lesser share in world exports to leave its exchange rate to market forces.
Hands-off approach
The hands-off approach opted by RBI in the currency market in 2010-11 can be appreciated from the extent of its intervention in the forex market. RBI's intervention was $1.6 billion in all of 2010-11, compared with $2.5 billion in 2009-10 and $35 billion in 2008-09. Further, except in June and during September to November 2010, the RBI did not sell or purchase dollars in the rest of the eight months.
What explains this hands-off approach of RBI when there was a case for RBI buying dollars to neutralise the inflow of forex and keep the exchange rate more competitive? By buying dollars, it would have added to liquidity in the economy and negated its anti-inflationary stance. Thus, the overall macroeconomic management necessitated non-intervention in the forex market.
When the central bank does not intervene, exchange rates are guided by capital flows. Capital flows, or the combined FDI and FII flows, came down significantly during 2010-11. While foreign direct investment (FDI) came down markedly, the increase in FII was only marginal.
FDI came down from $25.8 billion in 2009-10 to $19.4 billion in 2010-11, whereas foreign institutional investment (FII) flows increased to $24.3billion in 2010-11 from $23.4 billion in 2009-10.
Notwithstanding the overall decline in the combined flows from FDI and FII, the external commercial borrowings (ECBs) went up significantly to $25.07 billion in 2010-11 from $20.7 billion in 2009-10.
Thus, higher ECBs as well as slightly higher NRI deposits in 2010-11 prevented the depreciation of the rupee. On the demand side, corporates' preference for ECBs can be appreciated as domestic interest rates were higher in view of the rate hike by the RBI and the tight liquidity situation.
Exports and the economy
On the supply side, low interest rates in the developed markets as they pursued an easy money policy for the entire of 2010-11 to stave off recessionary trend have helped.
Interest rate differential between India and the developed markets widened significantly in 2010-11. The rate differential, however, did not attract FII inflows as one would have expected. This implies the confidence in the Indian economy did take a beating in the 2010-11.
In the context of managing the impossible trinity, the RBI has chosen the make the exchange rate more flexible to retain its independence on the policy front and without raising many eyebrows about capital controls.
Growth of global output and trade is expected to slow down in 2011-12. The government is thinking of doing away with the DEPB, an incentive scheme for exporters, on June 31, 2011. In this context, sustaining the high growth of exports is going to be a key challenge in 2011-12.
(The author is Chief Economist, Bank of India. The views expressed here are personal.)