Dr Bharat Jhunjhunwala
Common refrain is the slowdown in the global economy is leading to devaluation of the rupee. This argument is not acceptable. The US Dollar is rising despite the same slowdown. The rupee could have rise similarly. The true reason for the decline is increasing level of corruption. The cost of production of goods in India is rising because of this burden. The rupee is required to devalue in order to maintain export competitiveness.
The immediate reason for decline in the rupee is inflation. Inflation and exchange rate work in opposite directions. Copper coins were in vogue earlier in our country. Initially, the value of copper in a 1-paisa coin was equal or less than 1 paisa. Thereafter aluminium coins were minted. Reason was that inflation led to an increase in the price of copper. Value of copper in a 1-paisa coin increased to, say, 4 paise, while the legal value of the coin remained at 1 paisa. Thus, operators bought 1-piasa copper coins, melted them and sold the copper for a neat profit. This forced the Reserve Bank of India to withdraw the copper coins and replace them with aluminium coins. Further inflation has led to even these 1-paisa aluminium coins becoming outdated. This is how inflation leads to debasement of a currency.
Average rate of inflation in India in the decade between 2001 and 2011 has been about 8 percent. Prices have nearly doubled. The T-Shirt that was being produced in Rs 45 is now being produced in Rs 90. The value of rupee would have declined proportionally and fallen to about one-half had the American dollar remained stable. This would be necessary for the T-Shirt to continue to be exported to the United States. But inflation in America has been about 3 percent in this period. Therefore, tendency for decline in the rupee was somewhat arrested and the rupee should have declined only to about Rs 70. Think of it like this. One car is accelerating at 8 percent per minute while other is accelerating at 3 percent per minute. The difference between them will increase by 5 percent per minute. Similarly, prices are accelerating at 8 percent per year in India while they are accelerating at 3 percent per minute in the United States. The difference between them, therefore, will increase by 5 percent per year.
Surprise is that the rupee remained stable at about Rs 45 to a dollar and did not decline as it should have. Why? Reason is that exchange rate of the rupee is also influenced by capital movements. The exchange rate is determined in our foreign exchange market which operates much like a vegetable street market. The price of potato declines if there is increase in supply. Similarly the price of dollar declines if there is increase in supply of that currency. Huge amounts of foreign capital have come into India in the last decade in form of portfolio and direct investments. This has led to increase in supply of dollars, decline in the price of dollar and a corresponding increase in the price of rupee. The decline in the exchange rate of rupee that should have taken place due to higher rate of inflation in the country did not take place because the increase in price of the rupee due to this inflow overshadowed that tendency. It like continuous blood transfusion to a patient suffering from anemia would lead to the levels of hemoglobin remaining constant. Similarly, continuous inflow of dollars from foreign investments into the Indian economy suffering from inflation led to the exchange rate of the rupee remaining constant. The inflow of foreign investment has slowed down after global rating agencies have downgraded India beginning August 2011; and the rupee has started to decline rapidly since then. The decline, however, is not due to present events. The decline has been continuous since 2001-only it has manifested now after the inflow of foreign investment has petered out. It is, therefore, necessary for us to control inflation is we want the rupee to climb again.
Main reason for inflation is the increase in wasteful consumptive expenditures of the government. Idle Government servants are being given huge pay packets. Revenue is being used in their consumption expenditures. Often politicians and officials buy gold or make foreign visits. The purchasing power is transferred from India to Russia or South Africa in the process. The Indian economy deflates just as air leaks out of a balloon. The supply of rupees and demand for dollar increases in the Indian foreign exchange market. This leads to increase in value of the dollar and decline in value of the rupee.
Corruption leads to decline in the value of the rupee is yet another way. The cost of production in India increases. Say the cost of production of a T-shirt is Rs 55 and it sells in the United States for a dollar. Now the Sales Tax. Excise duty, factory inspector, water pollution inspector and other have to be paid grease money. This leads to the cost of production increasing to Rs 65. But the American consumer is willing to pay only one dollar. Export of T-Shirt in this situation can only be done if the value of dollar declines to Rs 65.
Increase in oil consumption has become a drain on our foreign exchange earnings. It has become necessary for us to export larger quantities of goods to earn this foreign exchange. This has, in turn, required us to keep the price of rupee low. Also, Indian companies are making outward foreign investments in a big way in acquisitions as Tatas have bought Jaguar. The inflow of dollars on capital account has substantially reversed. Previously mostly foreign capital was coming into our country. Now, Indian capital is going out of the country. This is creating demand for dollars and leading to decline in value of the rupee. The ongoing global crisis has not helped. Foreign investors have turned risk-averse. They are moving their assets towards the United States. This is depriving us of the capital that could have come to us.
The long run value of the rupee is determined by domestic inflation. The exchange rate of the rupee would have been about Rs 70 against the dollar today had technological upgradation not taken place. Perhaps it will stabilize around Rs 55 because of technological upgradation. This long term tendency of the rupee to decline was overshadowed by the short run inflow of foreign capital till 2011. This favourable circumstance evaporated because of deterioration in quality of Government expenditures; leading to increase in fiscal deficit; leading to downgrading of India’s rating and reduction in inflow of foreign investment.
Upshot is that improvement in governance and quality of Government expenditures alone will help revive fortunes of the rupee.
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