Strong rupee a must for India

The Indian Rupee (INR) has depreciated almost 6% against the US Dollar (USD) since January 2018. Since May 2014, the rupee has depreciated 15.5%, and since 1991, the INR has dropped in half relative to the USD. During these years (1991-2018), India’s GDP has grown by 6.7% per year, compared to only 2.7% in the US.

If India is getting stronger economically, why is it’s currency not reflecting that? After all, a currency is only worth what it can buy and if the rupee today is buying 6% fewer US dollars than it did in January, what economic progress have we made? Since 2014, a depreciating rupee has caused relative standards of living to be 15.5% lower in India compared to the US.

I believe, the rupee is significantly undervalued and is undermining the country’s growth. A weak INR makes imports more expensive and is inflationary. With oil constituting almost 66% of India’s total imports, the combined impact of a weakening INR and rising crude oil prices will push inflation higher — every 10% rise in the cost of imported oil adds almost 2% to India’s inflation (Economic Survey). It is immaterial whether that increase comes from rising oil prices or a depreciating rupee, the inflationary effect is the same.

On the other hand, a ten per cent appreciation in the rupee will save almost Rs 1 lakh crore annually in oil imports, reduce inflation and give the RBI room to lower interest rates. India also needs a massive infusion of capital equipment and high-value technology to enable its manufacturing sector to produce competitively-priced tradable goods that the world wants. A stronger rupee will make it cheaper to import the technology required to develop a robust manufacturing sector. Singapore’s charismatic leader, Lee Kuan Yew, built that country into a financial powerhouse by being single-minded about keeping the Singapore Dollar strong because he believed that it kept inflation low and allowed the government to build the infrastructure and institutions it needed to grow the economy.

Why is the rupee so undervalued despite India’s world-beating economic growth?

The single-biggest reason for the INR being undervalued is that it is not a fully convertible currency. It is convertible only for current account transactions but not for capital transactions. As a result, foreign investors cannot freely invest in India’s capital assets (stocks, bonds, real estate, startups etc.) and Indian companies cannot freely acquire foreign assets. These restrictions on the free flow of capital add a substantial risk premium to the exchange rate.

Currency controls to prevent capital flight may have been justified when India’s Foreign Exchange Reserves were low. But now the country has over $400 billion in reserves, and it is imperative that the RBI remove all controls and make the INR a fully and freely convertible currency. The ability to freely buy and sell assets will improve the confidence of foreign investors and enhance the flow of external capital into the country. Full convertibility will also provide greater flexibility for Indian companies to take advantage of investment opportunities and lower borrowing rates in overseas markets.

And while it is true that a weaker currency helps exports by making them more competitive, the composition of India’s exports is such that a weaker INR will have very little impact on the total value of the country’s exports. Almost 26% of the exports are value-added petroleum products, which get more expensive as the INR depreciates. Another 35% are gems, jewellery, and pharmaceutical products and because India has such a significant comparative advantage in those goods, it is unlikely that a stronger INR will adversely impact the price elasticities of these exports.

What is the fair exchange rate for the INR? According to the Purchasing Power Parity (PPP) theory, the correct exchange rate between the two currencies is one that makes the price of an identical product (or a basket of products) equal in both countries. The Economist magazine puts out an annual index that measures the cost of a McDonald’s Big Mac in different countries. In January 2018, a Big Mac in the US was $5.28 and in India Rs 180, which implies an exchange rate of Rs 34.09 per US Dollar, roughly where the exchange rate was in 1992. While the Big Mac index is a little tongue-in-cheek and deceptive, it is not that far off from reality. In 2017, India’s nominal GDP was $2.31 trillion, but in Purchasing Power Parity (PPP) terms, it was $9.44 trillion, four times higher. This suggests that Rs 66 in India purchases almost four times more than $1 in the US, indicating that in real terms, the rupee is significantly undervalued.

It is time for the Reserve Bank of India (RBI) to set the rupee free and make it a fully convertible currency. This will eliminate the risk premium and make the INR a stronger currency, resulting in lower inflation, lower interest rates, lower costs for importing oil and high-technology capital equipment, and increasing realised returns on foreign investments in India, thereby making India a more attractive destination for foreign capital.

The author is the founder, contractwithindia.com. Views expressed are personal.