Dollar, rupee and the budget

Since October 2014 the euro has slumped almost 20% versus the dollar as expectations of monetary tightening in the US and loosening by the European Central Bank have taken hold. A strong dollar and rising US interest rates is tough going for emerging market currencies at the best of times and more so following a period of easy money. The collapse of the Russian rouble, Nigerian naira and Ukrainian hryvnia could be explained away by the collapse in oil prices and geopolitical tensions, but the emerging market currency weakness is broad based. Versus the dollar the Brazilian real is down 28% and even the Indonesian rupiah, cosseted by long-term gas contracts with Japan, has lost 8.3%. Even the renminbi is at risk of popping out of its tight fluctuation band on the side of weakness. The Indian rupee is alone in bucking that trend. Since October, the rupee has hardly budged against a rampaging dollar and were it not for fear of the Reserve Bank of India’s (RBI’s) intervention, maybe it could have risen. Is this one of those disconnects from international trends often visited upon India that RBI should consider smoothing out, perhaps driven by the euphoria of a new government or speculation that India’s growth rate is rising above China’s? Or is it a sign of a fundamental revaluation of the rupee that will complicate monetary policy and the Narendra Modi government’s plans for Make in India? There are more grounds for the latter than you might think. The rupee is one of the most undervalued currencies. According to the International Monetary Fund (IMF), if you were to take a common basket of goods, the exchange rate that would make that basket equivalent in price in India and abroad is Rs.18.5 per dollar. This makes the rupee more than 60% undervalued. The only currencies more undervalued on this purchasing power parity (PPP) basis are the rouble and the hryvnia. Yet, despite this substantial undervaluation, India is running endemic trade deficits, not surpluses. According to RBI, the trade deficit for 2013-14 is $136.1 billion. There are two possible explanations for the missing surpluses. The first is that estimates of PPP are just wrong. PPP is an easy concept to understand, but hard to compute. People in different countries, with different income levels, demographic structures, traditions and tastes do not consume the same basket of goods, and so it is often not available for a fair comparison. It is striking therefore that other PPP studies come up with similar results. Perhaps the most well-known of these is The Economist magazine’s light-hearted Big Mac Index. The idea behind this is to find a product that is identical in all respects, yet sold abundantly in different places, and then calculate the exchange rates that would make the price of this identical product the same across the world. In India they use a McDonald’s chicken burger for comparison. According to The Economist, this sells for $4.79 in the US and Rs.116.25 in India, making the BigMac PPP exchange rate equal to Rs.24.3 per dollar. The second explanation for the missing surplus is that the difference between the current exchange rate and the PPP rate of Rs.18.5-Rs.24.3 to the dollar reflects India’s poor non-price competitiveness. It is a measure of the prize available if the Modi government were to use its mandate to dismantle the myriad interventions in the price mechanism and obstacles to making things in India. An example is India’s energy subsidies that lead to poor energy efficiency. Despite low per capita meat consumption—which is highly energy intensive—India consumes 17,485 British thermal units per unit of gross domestic product, or GDP (source: US Energy Information Agency), almost twice as much as the world average and five times as much in rich countries where energy use is heavily taxed, such as the UK. Replacing subsidies with income support where necessary, will lead to greater energy conservation and lower oil imports. Before the collapse in prices, oil accounted for 40% of India’s import bill. Small steps have already been taken in this direction, the cover of lower oil prices allows the government to take giant strides. The recent budget signalled a shift to replace price support mechanisms generally with income support. This switch will lead to a substitution away from currently subsidized food and fertilizer imports towards non-tradeables. Changing the way welfare is delivered, rather than its quantum, will be greatly helped by ancillary efforts such as rolling out Aadhaar, passing on more distribution of welfare to innovative states away from the central government and banking the unbanked. The latter, coupled with attempts to persuade gold investors to buy gold-linked financial contracts rather than physical gold, will also improve the trade figures. Gold can account for as much as 15% of imports at times of inflation uncertainty. Lower gold imports would be a nice bonus, but bread and butter competitiveness issues are about removing price distortions and obstacles to business. We have a measure of how much this is worth to the currency. If the Indian government implements half of what it needs to do, the rupee could buck the trend of weaker emerging market currencies. The reasons for strength should allow RBI to take a more relaxed attitude, though not so for Indian investors with non-rupee exposure or foreign investors underweight the rupee. Avinash Persaud is non-resident senior fellow of the Peterson Institute for International Economics in Washington and non-executive chairman of Elara Capital Plc in London.