India’s Trillion Dollar Question:

Is the Rising Rupee the Solution -- or the Problem?

Joshua FelmanInternational Monetary Fund

New Delhi

A disclaimer!

The views expressed in this presentation are personal. They are not necessarily shared by the IMF, its Executive Board, or its management.

Last week…

There was a major piece of economic newsSo important that newspapers put it on page 1Almost overnight, while the nation was sleeping….

India became a trillion dollar economy

India's Nominal GDP (US $ billion)

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The trillion-dollar clubThere are only 10 other countries with trillion-dollar economies

U.S.JapanGermanyChinaUnited KingdomFranceItalySpainCanadaBrazilRussia

While “large economy” and “rich” are not synonymous, per capita income will soon surpass $1,000, vaulting India into the ranks of the middle-income countries

How did this happen?

The arithmetic:In 2006/07, GDP was Rs 41 trillionDividing by the average exchange rate for last year, we get $926 billion

So, how did we get to $1 trillion already?The rupee GDP is growingWhat happened to the exchange rate?

Since mid-March, the exchange rate has appreciated sharply

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Roadmap of Presentation

Why is the exchange rate appreciating?

The trillion-dollar question: is the rising rupee a good thing – or a problem?

What are the RBI’s options?

Roadmap of Presentation

Why is the exchange rate appreciating?

The trillion-dollar question: is the rising rupee a good thing – or a problem?

What are the RBI’s options?

The inflation problem

To understand why the exchange rate is appreciating today, you have to go back to 2006Last year, economic growth spurted to 9 percent and the economy began to overheat

Production reached full capacityHousing prices soaredMost serious, inflation started to rise

Inflation increased sharply starting mid-year…

India: WPI Inflation Rate (seasonally adjusted)(3-month moving average of m/m percent change)

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Excluding food and energy

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At the root of the problem

Supply shortagesFood prices increased sharply because of poor harvests and increases in world prices

Excess demandCredit was rising rapidly – by 30 percent per year for 3 consecutive years“Too much money chasing too few goods”

The credit boom

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To slow credit, the RBI raised interest rates

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But then something unexpected happened…

In the past, whenever the RBI raised interest rates, firms borrowed less, and so spending and inflation slowedBut this time, firms merely turned around and borrowed from abroadCapital inflows into India surged to unprecedented levels

Inflows reached $6 billion a month – excluding ECBs!

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The RBI responded by intervening…

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…which inflated the money supply

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Incremental reserve money

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The “impossible trinity”The RBI had just fallen victim to the “impossible trinity”

Not possible to simultaneously:Target interest ratesTarget the exchange rateMaintain an open capital account

Previously, this was not a problemCapital account was tightly controlled

What changed?

India is globalizing rapidly

The statistics on India’s financial integration with the rest of the world are astonishing:

Total two-way gross flows on balance of payments transactions were $101 billion in 1992/93They were $237 billion in 2001/02And $657 billion in 2005/06

In other words:Doubling took nine yearsNear-tripling took only four

India’s globalization

More statistics:External flows were 47 percent of GDP in 1992/93And 91 percent of GDP in 2005/06.

This tremendous flow of funds across India’s borders is rapidly eroding the country’s capital controls

The “impossible trinity” is beginning to bite

How should the RBI respond?

Two options:Do somethingDo nothing

The appropriate response depends on whether rupee appreciation is good for the economy, or notOnce we have answered the question, we can consider the RBI’s options

Roadmap of Presentation

Why is the exchange rate appreciating?

The trillion-dollar question: is the rising rupee a good thing – or a problem?

What are the RBI’s options?

Advantages of rupee appreciation

As we have seen, appreciation makes India richer: rupee assets are worth more in dollars

Also, a strong rupee helps reduce inflationLowers import prices, notably for oil, other raw materials, and capital goods, lowering the cost of productionIt also reduces the prices of import-competing products, like steel

So, a strong rupee helps consumers

Disadvantages of rupee appreciation

A stronger rupee hurts exporters Export earnings are worth less in rupeesThough this is partly offset by lower input costsAlso, to the extent that a stronger rupee relieves inflationary pressure, it reduces the need for interest rate increases

Still, on balance, export profitability is likely to suffer and exports may slow

Significance test

How to balance these considerations?Obviously, difficult to balance consumers and producersPerhaps the issue can be side-stepped

Is the appreciation significant?Small appreciation = minor issueTo assess this, cannot just look at the rupee/dollar rate, because India exports to many countries

Appreciation against the Euro has been much smaller

Measuring the “real exchange rate”

To get a comprehensive picture, we average the various exchange rates, weighted by exports to different countriesThis is called the nominal effective exchange rate (NEER)Then the NEER is adjusted by differences in inflation, because if a country has appreciated in nominal terms because its inflation is lower, then it hasn’t lost any real competitivenessThis adjusted rate is called the real effective exchange rate (REER)

How has the REER moved?

Through January – before the recent sharp appreciation – the NEER had actually been depreciatingBut inflation has been higher than in other countriesSo, the REER has been rising, implying a slight loss in competitiveness

Until January, the REERappreciation has been modest

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REER IMF Revised

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Figure II.5. CPI Based Real Effective Exchange Rate and Its Components(1993=100)

India’s appreciation has been amongst the smallest in Asia

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Source: IMF, INS database.

Real Effective Exchange Rates(Percent changes, January 2006-January 2007)

AppreciationDepreciation

But the appreciation since January has been significant

Exchange rate has appreciated by 7 percent against the dollar and 4½percent against the euro

So, the REER is probably around 10 percent higher than its 1993/94 “base”

How would this appreciation affect exporters?

Depends on the existing level of profitabilityIf corporate profitability high, then a moderate appreciation will not materially change their competitivenessBut if profits are low, there could be difficultiesWhat is the current situation?

Overall, corporate profitability is exceptionally high

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More recent data

Analysis of October-December 2006 quarterly results of 808 companies (Business Standard) showed a:

67 per cent increase in net profits, and 35 per cent increase in net sales.

January-March results are still coming in, but they show a similar story

Exporters have been gaining global market share

IVIIIVIIIVIIIVIIIVIIIVII200620052004200320022001

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…but the appreciation could hurt some labor-intensive sectors

To summarize

Weighing the advantages and disadvantages is difficultRBI’s (and public’s) priority now is controlling inflationBut the REER appreciation is significant, and could hurt some key sectorsWhat are the RBI’s options?

Roadmap of Presentation

Why is the exchange rate appreciating?

The trillion-dollar question: is the rising rupee a good thing – or a problem?

What are the RBI’s options?

Sterilization: the first line of defence

Go back to the earlier problem: intervention to defend the exchange rate fueled an unwanted increase in the money supplyIs there any way to prevent this money supply increase?Yes! It’s called “sterilization”

RBI can buy up the excess rupees by issuing bonds (MSS) Or it can force banks to deposit these rupees at the central bank, so they can’t lend them out (CRR)

In fact, the RBI has issued MSS bonds…

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… moderating the increase in reserve money

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So, does sterilization solve the problem?

Not really!

Sterilization creates problems of its own

Problems with CRR increases

A tax on the banking system, as banks are forced to place funds in non-interest bearing accounts, rather than loan them out

Imposes a large and disruptive shock to the system: all banks are forced to come up with funds to deposit at the RBI

Not a problem for those which brought in foreign exchange and now have excess rupees. But what about the others?

Problems with MSS

MSS is less disruptive and more market-friendly, since bonds will be bought (only) by banks with excess funds But then the government has to pay interest on the bonds, potentially foreverThe interest costs mount with each dollar of interventionThis spending could be put to other uses, such as building roads, hospitals, and schools

Cost of sterilization

The annual “carrying cost” of the December-February intervention is about Rs 25 billionIf intervention continued at this rate for another three months, the annual cost would be Rs 50 billionIf it continued for a year, the annual cost would be Rs 100 billion!

How does China do it?

After all, China has intervened much more than IndiaThey have kept their exchange rate very stable against the dollar, amassing huge amounts of reserves, while keeping reserve money growth below India’s level!

Foreign exchange reserves crossed a trillion dollars in 2006

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Do they have a special technique of sterilization?

Not really. They also sell bonds and increase the CRR

Key difference: Chinese interest rates are much lower.

China actually earns more on its reserves than it pays on its sterilization bonds

Interest differential on Chinese and US securities

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But there are hidden costs

Chinese interest rates are low partly because they control the banking sector

They force banks to accept low interest rates and make loans to public enterprises

Then they recapitalize the banks when they make losses. Recapitalization has cost billions of dollars.

Also, intervention and sterilization create market risks

Interest rate riskIMF calculations in 2004 showed that a 100 bps increase in U.S./Euro bond yields would reduce the capital value of China’s foreign bond holdings by 10 percent, implying a capital loss of 2 percent of GDPNow, reserves are roughly twice as large

Currency riskAlso, each additional $100 billion in reserves would imply losses of 2/3 percent of GDP if the exchange rate appreciated by 10 percent

ImplicationsA sterilization policy would be costly and risky for IndiaSo, it may not be sustainableIf not, it could be disruptive when the policy is abandonedIn that case, it might be better not to embark on a policy of “guaranteeing” the exchange rate in the first place

Firms could still hedge their exchange rate risk in the forward market

This reasoning led the RBI to stop defending the exchange rate in mid-March

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Any other options?

The second line of defense: capital account regulations

Some small steps have already been take to discourage inflows:

Reinterpretation of pre-IPO capital inflows in real estate sector, to disqualify them as FII investment

But major changes would be difficultNow that India is so highly integrated with the rest of the world, major capital account restrictions would be highly disruptiveIt would also send a damaging signal to the business community that even fundamental reforms can be reversed

Earlier this year, Thailand imposed some partial capital controlsThe stock market fell 15 percent on the first day, forcing the authorities to repeal many of the measures

Capital account regulations/2

A more promising alternative would be to liberalize some of the remaining controls on outflowsThe RBI has been doing this, raising overseas investment limits:

For individuals, to $50,000 (October) and then $1,00,000 (April)For companies, to 300 percent of net worth.For mutual funds, to $3 bn (October) and then $4 bn (April)

ConclusionIndia is now living in a Brave New World, a globalized one, where the old policy approaches may no longer applyIn particular, one of the problems of success is that India is attracting large capital inflowsDealing with these inflows is difficult; no country has found the magic solutionIntervening to defend the exchange rate can help preserve export competitiveness, but it can endanger the inflation targetSterilization can “square the circle”, but is costly and ultimately not sustainableLiberalizing capital inflows is one possibility, but it is not acomplete solutionSo, the Reserve Bank has some difficult choices to make

What would you do?

Also, competitiveness is not just a matter of the exchange rate

The REER has been rising since 2002But exports of goods and services have roughly tripledAnd profits soared

How did this happen?

Many explanationsCustoms duties were reducedCapital controls were relaxedTransport and communications infrastructure improved

In short, India developed, and as this occurs REERs naturally tend to rise

Exporting is not an endIt is a means to achieving competitive firmsIt is this process that generates growth