The real rate of interest, adjusted for inflation, is way too high to encourage investment, and the govt is yet to announce its promised public-private partnership policy to build infrastructure
The government’s chief economic advisor, V Anantha Nageswaran, says he is not losing sleep over the falling rupee. We wish him long nights of peaceful rest and restoration. While the government and the RBI rest, the rupee will be hard at work, to give some respite to our exporters hit hard by Trumpian tariffs.
An overvalued currency makes imports cheaper than they would be at a fair exchange rate, while an undervalued currency makes exports cheaper than they would be at the fair exchange rate.
However, the government should wake up to announce the public-private-partnership policy to boost private investment in infrastructure promised in the Budget 10 months ago, in order to sustain growth momentum.
Poetic justice
To begin with, let us appreciate that the alarm at the rupee’s decline vis-à-vis the dollar is overdone. Chief Minister Narendra Modi had made fun of the rupee’s fall in the wake of the Global Financial Crisis and associated taper tantrums, to denigrate the then-prime minister, Manmohan Singh. It is poetic justice that he should be reminded of his hollow criticism then.
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That said, there is little that Modi can do if the rupee suffers as a result of the policies of President Donald Trump.
Nominal depreciation of rupee sharper
We should also note that the nominal depreciation of the rupee is sharper than its real depreciation. The nominal effective exchange rate of the rupee (NEER), an index computed by the trade-weighted average of six major currencies, its level in 2022-23 pegged at 100, had slid a little over 10 per cent, to 89.13, in October.
The real effective exchange rate (REER), the trade weighted average of six major currencies additionally adjusted for the relative inflation levels in India and each of these six economies, had registered a smaller decline by October, to hit 94.28.
Some Asian currencies stronger
Some Asian currencies, however, have strengthened against the dollar, meaning the rupee has depreciated even more against these currencies than against the dollar. Since India competes with some of these countries for dollar-denominated exports, a depreciating rupee helps Indian exports.
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While a ten per cent fall in the rupee’s exchange rate will not compensate for the 35 per cent tariff differential between India, burdened with a 50 per cent tariff on exports to the US, and most other countries that export to the US, slapped with 15 per cent tariffs, it will help Indian exporters target export markets other than the US. More than 60 per cent of all trade by volume has its price denominated in dollars, whoever the exporter and whoever the importer.
‘Real rate of interest’
The RBI has cut the repo rate by just 25 basis points, maintaining a steep real rate of interest. The real rate of interest is the difference between the nominal rate of interest, the one you and I pay when we take a loan, and the rate of inflation.
If the real rate of interest is negative, that is, the rate of interest on our loans is lower than the rate of inflation, the lender suffers depreciation, in real terms, of his assets by lending funds.
If the real rate of interest is exactly equal to the rate of inflation, the lender gets zero real returns.
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Ideally, the real rate of interest should be around 2 per cent. If inflation is 1.5 per cent, the nominal rate of interest should be around 3.5 per cent. If the rate at which the RBI lends money to banks, the repo rate, is 5.25 per cent, the rate in the call money market — the market for overnight loans from one bank to another — would cluster around that.
The rate at which banks lend to borrowers would be several percentage points above that, layering on the different premia for different levels of risk represented by the borrower.
RBI’s balancing act
The rate of inflation in October was 0.25 per cent. In other words, the real rate of interest for borrowers is pretty steep. Sure, inflation will not stay this low in the coming months. But the RBI does not anticipate an inflation rate that climbs above 4 per cent in the near future.
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It could have brought down the repo rate more sharply than by a quarter of a percent. It held its hand, probably, to prevent a falling rate of interest becoming another push factor to send the rupee visibly sliding further. It can intervene in the currency markets to keep the exchange rate soft. And the RBI has said that it would carry out open market operations in the currency market.
India runs a current account deficit, in the normal course. Oil is a major import. Its price in rupee terms would go up, as the rupee depreciates. Is the RBI prepared to let the rupee slide and let the price level move up? It is.
Rupee value and inflation
Inflation is pretty low right now, and so even if it moves up a couple of percentage points, that would not be majorly disruptive. That is the benign explanation. The more Machiavellian reason to let inflation go up is to spread the cost of boosting exports across society.
A fall in the exchange rate makes exports cheaper in foreign markets, but makes imported energy and other inputs more expensive, feeding inflation. Inflation erodes the purchasing power of all people with fixed incomes, that is most of us, who earn a salary or daily or weekly wages, or live off a pension or a fixed annuity. Even if a dearness allowance is added on eventually, in the interim, real consumption would go down.
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If the government were to boost exports with financial assistance for exporters, that would invite criticism in foreign capitals as trade-distorting subsidy. In any case, the government would have to borrow to give that export incentive, widening the fiscal deficit, restricting the government’s freedom of action, and creating the potential to create excess demand in the economy and feed inflation.
If the result of giving additional boost to exports either by way of fiscal support or by way of a cheaper rupee is to feed inflation at a time when inflation is very low, why not adopt both routes to help exporters?
Rupee value and capital flows
The rupee has been falling also because of low levels of capital inflow and steady capital outflow from the economy. If the net flows are outward, the demand for dollars would go up, depreciating the rupee. Of course, the RBI can dip into its forex reserves to supply dollars to the forex market. When the RBI sells dollars in the forex market, buyers hand over counterpart rupees to the RBI, that is, the RBI’s forex sales reduce the money supply, which, potentially, could increase yields.
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When gross fixed capital formation in the economy, particularly by the private sector, is stagnant at 30.5 per cent of GDP, and bank credit growth over the financial year so far, at 6 per cent, is well below the nominal growth rate of GDP, increasing yields is not a good idea from a growth perspective, and even worse for the government’s interest payment burden. So, the RBI would sterilise the money supply reduction by buying up bonds in the open market (this is why it is called an open market operation or OMO), paying with rupees that now add to the currency in circulation.
The RBI Governor’s statement on the most recent monetary policy says it would buy bonds and inject Rs 100,000 crore via OMO, while also intervening in the currency market.
Need for private investment in infrastructure
However, merely making liquidity available and tinkering with interest rates would not revive stagnant investment. A good start to that end would be to announce the long-delayed PPP policy for private investment in infrastructure.
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Capacity utilisation is about 75 per cent, so there is no urgent need for industry to invest in increasing its own production capacity. But they can invest in infrastructure, provided a viable policy framework is created for such investment.
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