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Pricing the rupee right

S. Venkitaramanan

THE RUPEE has dominated the news in the financial front over the last few weeks. The market seems to be little influenced by the RBI's words and actions. Perhaps, it seems to feel the fundamentals dictate a weaker rupee.

The RBI has, however, handled the situation with its customary panache. In spite of this, how long the market will remain quiescent is not clear. A fundamental disequilibrium in the market has to be solved. The central bank may blame speculators, but spe culation itself results from a perceived imbalance. The fact is that the needs of India's foreign trade are not -- and cannot be -- fully met by exports. This has its repercussions on fund flows and feeds the expectations of banks, which act as intermedi aries between those who demand and those who supply funds.

India's balance of trade seems to be edging towards an all-time high trade deficit. The trade deficit standing at $17 billions is likely to increase further if policies on opening up the economy remain unaltered.

Exports have been growing at around 12 per cent. The 2000 figure may be around $38.3 billions. Imports, which have gathered steam -- thanks to industrial growth and liberalisation -- are expected to be around $55 billions. The volume of imports also refl ects the higher burden of $2-3 billions on account of oil price increases. The trade balance is, thus, a staggeringly high $17 billions. This is the order of resources, which India has to find additionally, to keep financing its imports.

In any country, faced with a high trade deficit, the obvious way out is either quantitative restrictions or high duties or a devaluation. Quantitative restrictions are ruled out by various developments on the WTO front. Equally, we have bound ourselves t o certain limits on duties. I do not see how India can avoid resort to a costlier dollar in rupee terms to meet the problem posed by high trade deficit.

In absolute terms, the current account deficit also remains on the high side, although in terms of percentage of GDP, it is only 1.1 per cent. The absolute size of the current account deficit is around $4-5 billions. This is what has to be met by ``capit al transfers''.

Even with all the support given by invisibles, the current account gap -- the gap between exports of goods and services and imports of steel -- runs at around $4-5 billions a year. This gap is met basically from capital flows -- primarily investment flow s and NRI deposits. While the overall scenario does look robust, a cautionary note is justified in view of the structure of reserves and our major vulnerabilities. The NRI deposit overhang, of nearly $23 billions requires careful watching. So does FII po rtfolio volumes.

Let me now state the positives. In a comparative sense, it is not denied that the rupee is, by and large, stable and that India will definitely avoid any collapse, such as happened in South-East Asia. In our view, one cannot also quarrel with the RBI's g eneral thrust of confidence. We must grant that our financial infrastructure has been strengthened in the last few years. But all that does not distract from the signalling effect of the trade deficit.

As long as we are on a market-determined exchange rate, the market rate itself is increasingly determined by the market perception of vulnerabilities -- particularly the rising gap between imports and exports. So long as we have a policy frame which allo ws imports to increase without any limit or restriction, there seems to be no alternative except to apply the exchange rate instrument -- in the absence of recourse to other tools.

Our BoP figures have an inexorable logic, which is driving the rupee downward. Why does the RBI try to prevent this from happening? A lower rupee may well be what India (Inc) wants! Local industry will obviously not dislike it, considering the increasing and strong competition from imports from Korea, China, Taiwan and so on. Exporters will also welcome and respond favourably to a gentle easing of the RBI's controls on the downward movement of the rupee.

The RBI's current defences, sophisticated though they are, are increasingly of no avail against market forces. At the current exchange rates, there is a strong demand for forex, which is unmet by export earnings and investment flows. It seems better that the RBI prepares the country for the inevitable, instead of encouraging the illusion that the situation is totally manageable without the rupee sliding down a bit. Ultimately, in managing the BoP, it is the trade balance which is critical. Trade deficit , in turn, depends on the relative value of the rupee to the dollar. All things considered, there seems to be no escape from the RBI moving the rupee downward by, say, 5 per cent.

I am not recommending a very sharp fall in the rupee, which will have other repercussions, including those on debt service. The RBI will be in the best position to decide where exactly the rupee should rest. Those who favour devaluation should, of course , note that devaluation per se is no panacea for trade deficit. Considerable additional marketing efforts and quality improvements are needed if exports have to get a real boost following devaluation.

Similarly, devaluation may not help reduce the value of those imports which are insensitive to price -- such as defence, POL and so on. All the same, the forex market seems to perceive that the value of the rupee is the only weapon left in the hands of G overnment to control the increasing trade gap. We must discard the illusion that a strong rupee is a guarantee for the economic health of the country. Let us recall that in the early post-War years, Japan propelled its exports upwards mainly on the basis of a weak yen. In the present circumstances, a weaker rupee is the best defence for our exports and against the flood of imports to which we seem to have committed ourselves following the WTO agreements.

A weaker rupee will, of course, involve some inflationary consequences to the extent it will raise prices of imports. Fortunately, imports as a percentage of total demand are not, at present, higher than 10 per cent. The inflationary impact of a 5 per ce nt devaluation may not, therefore, be, as high as is feared.

The RBI states that it has set no target value for the rupee. In my view, it seems better for the RBI policy-makers to face upfront the problem before the country and settle on a float towards a specific lower value for the rupee. How exactly the transit ion is managed is better left to the Central bank's technical experts who have developed considerable skill in managing the forex market operations.

What is important is that the country should be prepared to face the consequences of high trade deficit by manipulating the exchange rate. We cannot continue to sustain the deficit by capital flows, which are inherently not predictable. The answer to our problem of high current account deficit lies in correcting the trade imbalance. In the given circumstances, that can occur only through exchange rate adjustment, given our constraints on raising duties and on quantitative restrictions. Both the size of our exports and the continuing drain of forex on account of attractive imports show that we have necessarily to use the tool of exchange rate adjustment. So long as we do not do it, the central bank will be only shadowboxing and blaming speculators. The basic disequilibrium, which exists in the trade account, has to be corrected by adjusting the value of the rupee downwards.