All is not well with the Indian economy. Growth has slowed. In the April-June quarter of 2013-14, growth slid to 4.4 per cent. India’s economy grew at 5 per cent in 2012-13, against 6.2 per cent in 2011-12.

Current account deficit (CAD) widened from 4.2 per cent of GDP in 2011-12 to 4.8 per cent in 2012-13.

There has been a fall in both public and private sector investment.

Contraction in the manufacturing sector widened to 1.2 per cent, from one per cent a year earlier. Virtually everyday, news of the falling rupee is splashed across the front pages of newspapers.

There are two aspects to this story: why the rupee is falling, and whether the fall benefits our exports and CAD. But let us take the second point – of whether the rupee fall helps us—first.

EXPORTS may not BENEFIT

Some optimists hold the view that rupee depreciation is good for our exports. Here, data suggest otherwise.

A look at our major export items suggests there is a change in its composition from price-sensitive items such as leather footwear, dairy products, beverages, textiles and apparel, to less price-sensitive items such as refined petroleum products, chemicals, mineral products (especially, mineral fuels, bituminous substances, etc.), and machinery and transport equipment (engineering goods).

The share of petroleum products in India’s export basket increased dramatically from around 2 per cent in 1993 to around 20 per cent in 2012. The surge in exports in the case of petroleum items is because of India’s potential in oil refining activities.

On contrary, India’s CAD is likely to increase further as oil and precious metals still contribute to bulk of our imports. Controlling CAD is an important factor from the perspective of sovereign rating.

Countries with higher CAD generally lose out in terms of investor attractiveness. Therefore, the merits of a falling rupee are not really clear.

Now, to why the rupee is falling. In order to explain this story, we will have to connect a few dots – exchange rate, inflation rate, fiscal deficit, CAD, exports, imports, and the US economy.

Under a floating exchange rate regime, the market determines exchange rate. In economics, there are two ways to determine the correct value of exchange rate.

First, is the goods market approach where an attempt to find the correct value of exchange rate is based on the assumption of ‘law of one price’ (LOOP), using the concept of purchasing power parity (PPP). LOOP states that in the absence of transport and other costs such as tariffs, identical (similar) goods will sell for the same price. Because of the combined activities of arbitrageurs, identical goods, primarily financial assets, cannot sell at different prices for long.

The prices of homogenous goods, once converted to common currency, should be same in spatially separated markets. In fact, the magazine, The Economist , publishes the Big Mac Index, which serves as an informal way of measuring PPP between two currencies. The index takes its name from the Big Mac, a hamburger sold at McDonald’s restaurant in various countries.

If LOOP, or the Big Mac principle, holds true, then real exchange rate is one. Therefore, if domestic inflation is higher than the US inflation, the rupee is expected to depreciate against the US dollar ($).

Second, is the asset market approach, where the value of exchange rate is conditional upon the inflow and outflow of capital into and from the domestic economy.

What determines these inflows and outflows? In foreign exchange markets, expectation plays a crucial role. High fiscal deficits and higher inflationary expectations, makes domestic assets (government bonds) less attractive.

Currency depreciates (following asset market approach), as foreigners pull out money from the domestic capital market. Stock market tanking every other day is an indication of this trend. And, countries with higher CAD lose investors.Therefore, whichever way we approach the issue, understanding the drivers of inflation is crucial to understanding exchange rate movements.

INFLATION DRIVERS

How does one explain inflation in India? One school of thought holds the view that inflation in India is because of factors such as increased transfers through MGNREGA, higher minimum support price for farmers, and now, the government committing to spend around Rs 1.3 lakh crore per annum on account of food security Bill. Money spent without increase in storage capacity in the case of food security Bill, or without infrastructure projects being completed in the case of MGNREGA, is bound to cause inflation.

Questions were raised about the effective usage of government money on health and education. To take the case of Sarva Shiksha Yojana, there has been a rise in literacy and gross enrolment ratios (at the primary level), which has been attributed to the programme. But these achievements do not tell us whether the quality of education has improved.

Critics argue that although development indicators have improved, money is not being well spent, as quality of service has not improved. Add to this, corruption and one finds perfect recipe for inflation.

Fiscal deficit, and with it, inflation, is likely to increase further with the formation of new states such as Telangana, with more resources being used to spend to set up adequate administrative infrastructures (secretariat, police, revenue department, etc.). Adding to these domestic factors is the US economy showing sign of revival.

There is indication of quantitative tightening where the Federal Reserve is likely to reduce government bond purchase by $10 billion per month (from $ 85 billion to $ 75 billion).

This has further strengthened the US dollar against most Asian currencies. The likely attack by US on Syria has already pushed up the crude price to $113 per barrel. In fact, gold in international markets is now trading at $1400 per ounce (around 28.3 gram). In India, gold is trading at Rs 34000 per 10 gram, whereas it should have traded at Rs 24,000, with Rs 50 to $1 as exchange rate.

VALUE FOR RUPEE

How does one arrest this fall? First, create an environment for long-term capital investment. Capital-surplus countries such as Japan are keen about investing in our infrastructure. This is, however, conditional upon creating the necessary environment for investment. Second, we should build better trade relations with Iran.

This will allow India to import oil in rupees and not use up precious dollars. This is not happening for fear of US sanctions.

Third, proper monitoring and implementation of government-funded programmes is important. A reforms push such as direct cash transfer is a welcome move and is expected to plug leakages in the system.

Likewise, money sanctioned under any particular scheme, say, under SSA to build schools, should be allowed to be used for next best alternatives, say, building hospitals, if the village already has a school. This will ease inflation and may arrest a fall in rupee.

The author is with Glocal University

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