All is not well when it comes to India’s trade deficit and value of the Indian rupee. While the trade deficit has widened to a record $25.63 billion in June, latest data suggests the rupee for the first time has crossed the 80 mark against the US dollar.
There are two aspects here: why the rupee is falling, and why the fall is not benefiting India’s exports and increasing the current account deficit (CAD).
Some optimists hold the view that rupee depreciation is good for our exports. However, data suggests otherwise. A look at the major export items suggests these are income elastic, that is, they tend to perform well when there is an upsurge in foreign income.
In India’s case, there has been a change in the composition of exports from price-sensitive items such as leather footwear, dairy products, beverages, textiles and apparel products, to more income-sensitive items such as refined petroleum products, iron and steel, chemicals, machinery and transport equipment (engineering goods), and pearls and precious stones such as diamonds.
For example, the share of refined petroleum products (high-speed diesel, motor spirit, aviation turbine fuel, naphtha, etc.) in India’s export basket increased dramatically from around 2 per cent in 1993 to around 17 per cent in 2021. The surge in exports in the case of petroleum and metal items is because of India’s potential in oil refining and mining activities.
However, the Russia-Ukraine war and the onset of weak global economic growth meant a lower demand for income elastic items that comprise a major chunk of India’s exports basket.
As per July 2022 estimates, real GDP in the Euro area is expected to fall from 5.4 per cent in 2021 to 2.3 per cent in 2022. Government debt as a percentage of GDP increased from 83.8 per cent in 2019 to 96.4 per cent during the first two quarters of 2022. In China, India’s another major trading partner, GDP growth rate is likely to come down from 8.1 per cent in 2021 to below 5 per cent in 2022.
The US is also witnessing a surge in inflation (above 9 per cent mark), denting the growth in real GDP. And all these explain why India’s income elastic exports items are suffering.
Intra-industry trade
Even considering the price sensitive items such as leather footwear, textiles and apparel, etc., we find that India is losing out to its competitors such as China, Vietnam, and Bangladesh, because of qualitatively ‘low value’ export items. This is particularly true for trade in similar commodities, that is, ‘intra-industry trade’.
With the gradual lowering of the industrial tariff across countries, the incidence of overlapping trade flows within product categories have become a common phenomenon. So in the case of India, while the exports were growing, imports were growing even faster resulting in a growing CAD. The share of domestic value-added content in foreign final demand went up by 6.2 per cent, from 32.6 per cent in 2005 to 38.8 per cent in 2020.
Take the case of the pharmaceutical industry, an important sector in intra-industry trade. India continues to sustain higher trade deficits in certain segments of Active Pharmaceutical Ingredient (API) and medical equipment. In fact, India lacks comparative advantage in manufacturing other Covid-19 related medical items, such as medical and non-medical wearables, disinfectants and sterilisation products. Similar is the case with textile and apparel industry. The government, on its part, has undertaken a series of interventions to make Indian industry and products competitive. Some of the key initiatives include establishment of the National Manufacturing Competitiveness Council (NMCC) in 2004, launch of the ‘National Manufacturing Policy’ in 2011, introduction of the ‘Make in India’ scheme in 2014 and ‘Atmanirbhar Bharat Abhiyan,’ in 2020.
However, the impact of these initiatives in making our exports competitive is yet to bear fruit. On the contrary, India’s CAD is likely to increase further as crude oil, precious metals and coal still contribute to bulk of our imports, and are necessary items for a growing economy like India.
The exchange rate
Under a floating exchange rate regime, the market determines the exchange rate. In economics, there are two ways to determine the correct value of the 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. Therefore, if domestic inflation is higher than the US inflation, the rupee is expected to depreciate against the 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.
In foreign exchange markets, expectation plays a crucial role. High CAD and higher inflationary expectations make domestic assets (government bonds) less attractive. Over the last one year, foreign institutional investors (FIIs) have been net sellers in the domestic stock market.
The World Investment Report published by UNCTAD shows foreign direct investment (FDI) fell by 30 per cent to $45 billion in 2021. India’s foreign exchange reserve also fell below $600 billion during the first week of July. Currency depreciates as foreigners pull out money from India.
How does one explain inflation in India? One is because of the higher cost of energy and crude oil in the international market. The war, which has led to the imposition of sanctions, has reduced the supply of Russian gas and oil. It caused disruption in the agriculture value chain causing world food shortage. The substitute is the pricier US energy, which means a higher crude and energy price in the international market.
In fact, a depreciating rupee may add-on to the inflation numbers by making imports costly. Quantitative tightening is not going to help in the event of supply-side disruption and when there is lesser availability of foods in the market.
Although the inflation numbers, both CPI (7.02 per cent) and WPI (15.9 per cent), dipped a little in June 2022 in comparison to May, the recent imposition of Goods and Services Tax on pre-packaged food items is likely to increase inflation numbers.
Going by LOOP, we should not be surprised if the value of rupee touches the 83 mark within the next six months.
The writer is Professor, School of Management, Mahindra University