Why the RBI should let the rupee fly

The late scamster Harshad Mehta once told me that if you want the country to be rich, you must have a strong currency. I didn’t fully follow his intricate logic then, for a strong currency is a consequence, and not a precursor, to building a strong economy.

The India story so far has taken a different route: we have strengthened our economy by artificially holding down our currency. It’s not very different from the way China has built its economy. But it is time to rethink this unholy fetish for a weak currency. It flows from our tendency to privilege exports over imports since we want to hoard foreign exchange. The hoarding instinct is almost always the result of a past shortage psychosis. Thus we will sit on piles of useless foreign currency when it can be put to better use. China has $2.4 trillion of forex reserves - more than twice the size of the Indian economy - and India $260 bn (excluding gold).

Are high reserves a sign of ruddy health or economic diffidence? The official argument in favour of a weak rupee is that it will affect exports, but this is a very short-term view and assumes that India’s exporters are morons incapable of adjusting to new realities. The truth is that a cheap rupee reduces the pressure on Indian manufacturers and service providers to become more competitive by improving productivity.

To be sure, a strong rupee will create its own losers. Domestic manufacturers and exporters with a large rupee cost base will be hardest hit — and they will be forced to improve productivity or shut shop. Our farmers and horticulturists will also face the winds of competition - and that’s not a bad thing when food prices are going through the roof. Our farmers may thus need short-term protection to give them time to adjust.

On the other hand, look at the plus side of the balance-sheet. A stronger rupee will douse inflation faster than a stable one, since we import more than we export. Consider the possibilities.
First, oil. The government has been pussy-footing around oil prices because it does not have the guts to take the politically tough decision to deregulate. But let the rupee gain 10 per cent or more and the oil bill comes down by the same amount. A canny government will allow this to happen and adjust the taxes upward so that the pump price remains the same. The resultant short-term tax booty can be used to ease adjustment pressures when oil prices start zooming — as they surely will.

Second, trade will shift towards goods with high import content since exporters will import cheaper raw materials and export value-added stuff. This is the story of our gems and jewellery export success. There’s no reason why it can’t be replicated in electronic goods, automobiles or anything else. Far from depressing exports, a strong rupee will stimulate the right kind of exports.

Third, our capital costs will come down dramatically as everything from nuclear power plants to industrial machinery will become cheaper. Cheaper electricity and cheaper industrial goods will improve our overall cost competitiveness in the medium term.
Fourth, it will allow Indian firms to become truly global. Most Indian success stories — Infosys included — are really cost arbitrage stories. They buy cheap Indian labour and displace costly US or European labour through a process called offshoring. Since Infosys’ competitors are on the other side of the earth, we steal their jobs while they sleep.

But this is the bottomline: we export because we are cheap. Which is not exactly the way to robust competitiveness. Also, a weak rupee artificially makes Indian labour look cheap. A true multinational should not only be offshoring costs, but multi-shoring it. A strong rupee will make it easier for an Infosys to hire more US and European techies — making it less politically vulnerable to protectionism.

Moreover, a rupee that commands a better dollar rate will be able to buy more assets abroad cheaper — whether it is oilfields or steel or automobile companies. The Tatas would not be struggling with Corus and Jaguar-Land Rover if the rupee had been stronger then.

An interesting speculation: where will the rupee be if allowed to float freely without the Reserve Bank’s nannying? A good place to seek an answer is India’s GDP on the basis of purchasing power parity (PPP). At $3.56 trillion in 2009 (according to CIA estimates), it’s nearly three times the nominal GDP of $1.22 trillion. This means a dollar spent in India can get you three times the goods it can in the US. Of course, this rule of thumb is too simplistic, since the exchange rate is determined by many factors, including capital flows, deficits, relative prices — the works.

If allowed to float freely, the rupee could rise toRs 30-35 to the dollar in two years’ time, other things being equal. The RBI should let the rupee fly - and only try to control the rate of ascent by spacing it out.