Calcutta Notebook


Why the rupee must decline? India faced a similar situation 20 years ago. The foreign exchange rate was then fixed at Rs 15-to-a-dollar by the Reserve Bank of India. Exports were lagging and imports were increasing. An overvalued currency leads to an increase in imports because Indian buyers get dollars cheap. It leads to decline in exports because Indian exporters get fewer rupees for their dollar earnings. This was the genesis of the Balance of Payments crisis of 1991. Indian foreign exchange reserves had depleted because the Government had embarked on a policy of maintaining a strong rupee. The Government had to fly gold reserves to the UK to borrow dollars temporarily and prevent a sovereign default.

Solution, however, came after the reforms of 1991. Manmohan Singh dismantled the fixed exchange rate regime. In a short span of time the rupee declined from Rs 15- to Rs 25-to-a-dollar. Imports became expensive. Indian purchaser would now have to shell out Rs 25 for, say, a pen made in the US against Rs 15 that he was paying previously for the same. Imports declined and exports increased. The crisis abated for the time being.

But today imports are rising while exports are down. Trade deficit is increasing. The solution being implemented by the Government this time around is entirely different though. Instead of earning more dollars by devaluing and pushing exports; the Government is trying to get the dollars by increased flow of Foreign Investments. This was the agenda of The Prime Minister's meetings with Angela Merkel, Chancellor of Germany during his visit few months ago to the European Union. Manmohan Singh wanted German companies to invest in India. Speaking at the closing ceremony of the Days of India in Germany he said: ‘‘Our message to the world is clear: India remains open and welcoming to foreign investment. We are aiming to attract an investment of nearly one trillion dollars in infrastructure over the next five years. I hope German companies and companies from across Europe will make good use of these opportunities..." One of the main objectives of the EU-India Free Trade Agreement which is under negotiation is to attract more foreign investment.

The strategy of attracting Foreign Investments to meet the Trade Deficit is like selling of shares by a loss-making business. FIs would invest in companies that are making profits. But Indian companies cannot make profits if rupee is overvalued because they will be faced with competition from cheap imports. Thus trying to attract foreign investments by maintaining a high value of rupee is not possible. High value of rupee will lead to loss to Indian businesses and FIs will run away. Hence the strategy of attracting large foreign investments to manage the trade deficit is fundamentally flawed.

Why is the Government so reluctant to allow the rupee to depreciate? The reason seems to stem from two considerations. First consideration is that devaluation would impose huge losses on foreign investors. An investor who ploughed in, say, 100 US dollars at an exchange rate of Rs 55, would have bought Indians shares worth Rs 5500. Now, if the rupee devalues to, say, Rs 70-to-a-dollar, he would get back only $80 from the sale of his shares. He would suffer a loss of $ 20 even though the company in which he has invested may be doing well. The possibility of such a loss being incurred may lead to a stampede to get out of India. That would destabilize the economy, something to be avoided as elections are approaching.

The second reason appears to be to protect the Indian nationals who have round-tripped their money into India. It works like this. An Indian national makes No 2 money of say Rs one crore in India. He sends it to a Swiss Bank. But Swiss Banks pay almost zero interest rates. So he sends his money from Switzerland to Mauritius and from there it comes to Mumbai in the guise of Foreign Investment. These Indian nationals will suffer huge losses if the rupee devalues.

he real reasons for the Government pushing to maintain a high rupee is its anxiety to attract more foreign investments. This is not likely to succeed because the overvaluation of the rupee will put pressure on the profitability of Indian businesses and discourage foreign investment. The only solution to the burgeoning trade deficit is devaluation of the rupee. Done gradually this will prevent a run on the rupee and also bring the trade deficit under control. Done suddenly it has a destabilizing effect. The fact that the rupee has declined by about 10 percent within a short span of a month arises from the fact that the Government tried desperately but failed to keep the rupee up. Had the Government let the rupee decline naturally this could be avoided. High rate of domestic inflation leads to debasement of the Indian currency, Devaluation is its logical outcome.

Vol. 46, No. 7, Aug 25-31, 2013

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