There were calls for the Reserve Bank of India (RBI) to intervene in the forex market to contain the strengthening of the rupee largely to support the export-sector recovery. There were even suggestions to continue the export incentives that were part of the overall stimulus packages of 2009.
These suggestions are based on the assumption that in India, a weak rupee would encourage exports, and thus, help the overall growth recovery. Many economists have argued for intervention in the forex market, and some Asian economies, notably China, maintain artificially under-valued exchange rates to maintain international competitiveness.
The important question is: Do we have any clear-cut proof that suggests whether exchange rate appreciation (or depreciation) has any significant impact on exports in the post-reform (post-2002/03) period in India? At least based on the recent literature, the answer is no. But the issue is important for policy makers, who may be constraining growth by manipulating the rupee’s value in foreign exchange markets. It is a separate issue whether an export-led growth strategy is relevant or not. Of more interest, should exchange rate policy solely aim at export promotion in isolation, disregarding the growth effects of imports?
In a recent research paper we failed to establish the theoretical positive impact of the exchange rate on exports. But we find that changes in the exchange rate strongly affect imports. Additionally, we find a strong uni-directional causation running from imports to exports, and not vice versa.
This is particularly pertinent for Indian policy makers. The impact of the exchange rate on exports appears to pass through imports. Hence, one can argue that exchange rate appreciation indeed could have a positive impact on exports through reduced input costs (and price) and improvements in competitiveness (through cheaper technology imbedded in imports).
Furthermore, evidence suggests that exports and imports of firms are highly correlated, and exports are largely driven by imports, with other control variables such as innovation playing a minimal role. This suggests that Indian firms’ competitiveness depends, in part, on low cost inputs imported from abroad. One may remember the most significant trade policy reforms in India resulted in a sharp rise in total trade because of the substantial reduction in import tariffs.
Overall, these results suggest that India’s exchange rate policy, which is generally aimed at supporting exports, will need to be re-evaluated.
Exchange rate policy should not aim at export promotion in isolation, instead it should balance both exports and imports growth. This will, in turn, help Indian firms to export more and, more importantly, facilitate firms to achieve a higher level of productivity and efficiency.
The central bank’s intervention to control any rupee appreciation may be risky for India’s overall long-term recovery process. During the very recent appreciation period, the RBI has done a wise job in not falling into the trap of keeping the rupee weak to help exports. It had rightly focused on controlling inflation by hiking interest rates rather than focusing on exchange rates and exports.
If the RBI intervention is warranted to ward off appreciation following speculative capital inflows, then going for capital controls could be a sensible option. But the ‘real’ appreciation needs to be allowed to improve economy-wide productivity and competitiveness in the international markets.
N R Bhanumurthy and Chandan Sharma are with National Institute of Public Finance and Policy and the FORE School of Management, respectively.