Rupee Appreciation: Lessons from China

Op-ed in Business Standard, New Delhi

May 22, 2007

The lesson for India is not that it should revert to distorting the price of capital but eliminate the distortions in the use of labor.

There are two views on the exchange rate in India. In the first, the real exchange rate is seen not as a determinant but an outcome of development, and hence best left to markets. This view calls for a completely flexible exchange rate policy, except for occasional intervention to limit large currency movements, and complete openness to capital flows. This view is coherent because flexible exchange rates and free capital flows are compatible. It is plausible because as long as the exchange rate reflects underlying productivity performance-supported by the rising share of corporate profits in GDP-there is no real worry that exchange rates could become overvalued, and hence harmful for exports and growth. That this view is coherent does not mean that it is right or politically easy to sustain, especially when currency changes are large.

A second view is the real exchange rate is an important determinant of long run growth and hence needs to be managed through sterilized intervention as in China. If China can pull this off-under more difficult circumstances because it receives more foreign capital flows and runs a current account surplus both of which create greater aggregate demand pressures-why not India? This question merits a serious response.

China's ability to sustain its competitive exchange today stems in part from a combination of financial repression and autocracy. Chinese interest rates are kept very low, even negative, which bears little relation to the real return on capital of at least 10 percent. When China sterilizes the monetary impact of capital inflows and current account surpluses, its central bank issues debt at about 2 percent most of which has to be bought by domestic state-owned banks-the political system probably leaves the banks with no options but to (involuntarily) hold this debt. China is in effect taxing the banking system today, avoiding incurring a fiscal cost in the present, but actually accumulating a large fiscal burden for the future, when banks will have to be recapitalized. Sterilization at artificially low interest rates also means that sterilization itself does not create an inducement for further capital flows; it can therefore be sustained for longer.

Can India imitate China? Sure it can, provided it can go back to taxing banks, keeping interest rates artificially low, and adding to its already large fiscal burden (which is greater than in China). Is this a plausible economic strategy given that the thrust of reforms has been to precisely move away from financial repression and fiscal profligacy? Clearly not.

So, India cannot really follow China and yet, India cannot afford to neglect the real exchange rate. Commentators suggest that currency appreciation is less of a problem today either because exports are mostly of IT-services where profit margins are large enough to absorb adverse currency movements; or because exchange rate changes reflect productivity developments and hence not a matter for concern. But we have to beware of the "Bangalore Bug," whereby currency appreciation driven by the productivity of skill-intensive services undermines the competitiveness of low margin, labor-intensive manufacturing that are going to be crucial for India's long run ability to boost employment creation. Here, we should be thinking of the incentives not just facing existing low-skilled manufacturing firms but also firms that are potential entrants into this sector. We have not yet sorted out the regulatory problems that would allow Indian unskilled manufacturing to come into its own but a necessary condition for that to happen is a competitive exchange rate, and one that is not determined entirely by the performance of skill-intensive services.

What should India do? Three policy responses, one each in the short, medium and long run, might be considered. All of these will make clear that "doing something" about the exchange rate is a call that is easier made than implemented. We should not harbor any illusion of easy, painless solutions.

The first follows from a lesson that is essential to absorb: India's ability to manage the real exchange rate has been severely undermined by capital flows. There is no need for India for further policy actions that will lead to greater capital inflows. Indeed, there may even be a case for tightening, especially of external commercial borrowings, which were surprisingly relaxed in the last year, and, if feasible, some tightening of other short-term (hot) flows. It has to be recognized, though, that major restrictions on capital flows will damage market confidence, and minor ones, while helping minimize future problems, cannot fully address current ones.

In the medium run, improving the fiscal position remains one of the key policy tools that can help counter real appreciation. Unlike monetary policy and sterilization, which largely affect nominal variables, fiscal consolidation can increase domestic savings and hence exert downward pressure on the real interest rate, causing a depreciation of the real exchange rate. Fiscal consolidation is desirable in its own right, but the government should consider making a special effort at improving government finances in response to episodes of sustained appreciation.

In the longer run, the ability to sustain a competitive exchange rate will require strengthening the key factor that underlies value creation in India-its labor. This includes attacking the last bastion of the licence raj-higher education-to augment the supply of skilled labor. Wage increases averaging 12-14 percent in the last few years signals emerging shortages in the supply of skilled labor. Policy actions also include, crucially, addressing the impediments-labor laws and better basic education-that prevent the utilization of India's vast pool of unskilled labor. Perhaps a deeper reason for China's competitive exchange rate might simply be that it has used-more effectively than India-its vast pool of labor which has kept a lid on wage growth and inflationary pressures.

Thus, strangely enough, China's exchange rate reflects, and is sustained by, distorting the price of capital while using labor relatively efficiently. So, the lesson for India is not that it should revert to distorting the price of capital but rather to eliminate the distortions in the use of labor. That might offer a surer route to a sound and competitive exchange rate in the long run.