Has the time come to ask if the rupee is getting too strong for India’s good? In an interview to CNBC-TV18, Sonal Varma, MD & Chief Economist at Nomura, Deepali Bhargava, Economist at Credit Suisse and Ananth Narayan, Head of Markets at Standard Chartered Bank discussed whether strengthening rupee is worrisome.
Has the time come to ask if the rupee is getting too strong for India’s good? There is gathering evidence.
One, since April India’s trade deficit has been expanding to an average of USD 13 billion versus an average of USD 9-10 billion in the past year. Yes, July has been milder, but that is largely because of domestic goods and services tax (GST) dislocations.
Two and more specifically, India’s non-oil, non gold imports have jumped to an average USD 25-27 billion since April versus less than USD 22 billion up until March. Does this indicate that manufactured imports are getting cheaper than domestic goods?
Three, India’s manufactured exports have been falling since April. Does this also indicate the rupee has become too strong for Indian exporters to be competitive?
The manufactured imports are also coming at a time when India’s domestic industrial growth is pathetic. The last Index of Industrial Production (IIP) reading was as poor as minus 0.1 percent. So is it that there is weak industrial growth, but even within that weak industrial growth a large part of domestic consumption of industrials is being replaced by imported manufactures?
In an interview to CNBC-TV18, Sonal Varma, MD & Chief Economist at Nomura, Deepali Bhargava, Economist at Credit Suisse and Ananth Narayan, Head of Markets at Standard Chartered Bank discussed whether strengthening rupee is worrisome.
Below is the verbatim transcript of the interview.
Q: In the first place, what is your math indicating, do you think the rupee is overvalued in real effective exchange rate (REER) terms on a trade weighted basis?
Varma: The simple REER calculation would show that INR is overvalued. However, I think the broader measures of valuation, there is productivity adjusted REER, there is a fundamental equilibrium exchange rate model. If you look at an average of all the models and not just a simple REER metric, then actually our estimate shows that rupee is 2 percent undervalued and not overvalued as the simple REER metric would suggest. So, we don’t think rupee is overvalued.
Q: Is the rupee overvalued vis-à-vis Indian competitors like for instance the yuan, the trade deficit which China is rising?
Varma: I think especially when we are talking about China because China accounts for almost 50 percent of the trade deficit that we have on an aggregate, so it is not surprising the focus comes on China. So, I think it is important to look back at how things have progressed over the last 10-12 years. I am specifically referring to the period from 2005 to 2013 where INR on a nominal basis depreciated close to 90 percent against the Chinese yuan.
During this period despite INR depreciation, India’s trade deficit with China actually went up from 0.2 percent of gross domestic product (GDP) to about 2 percent of GDP. In the last three years, where rupee has appreciated slightly against China, our trade deficit with China has remained more or less stable. What it suggests is that our trade deficit with China is actually not that currency sensitive and almost 65-70 percent of our trade deficit with China is machinery imports.
So we are importing all kinds of boilers, electrical machinery from China which continues despite the currency moves. So, it looks like it is still a lot more cost effective. Maybe the delivery is a lot more efficient, a lot faster, and all these factors seem to be outweighing the currency moves. So, I think it does not look like specifically when we are talking about China that FX is to blame here.
Q: What is your sense, are we in overvalued terrain, say year-to-date (YTD) on a one year rolling comparison and say on three year basis?
Narayan: Opining on whether the rupee is overvalued or not is always going to be a topic fraught with opinions. There is no math behind this to determine what the absolutely perfect level of the rupee is. As Sonal Varma mentioned, even the REER model is subject to a lot of interpretations; should we include productivity gains, how much of productivity gains, differentials are there, etc. I would go on a more basic principle.
Clearly the rupee has outperformed most of its peers despite the fact that dollar has been by itself weakening this year, rupee has been strengthening against most currencies, not just the dollar, and has outperformed in over the last one year. Now what accounts for this outperformance of the rupee, this softening of the dollar against the rupee is best reflected in the fact that the Reserve Bank of India (RBI) has actually been mopping up a lot of dollars in the spot and forward markets. If you see from the beginning of this year, the RBI spot reserves have gone up by USD 33 billion and the forward purchase of dollars that the RBI does has gone up by about USD 20 billion.
Now where has this USD 50 billion odd come in from? It is not explained by a current account deficit, we still have a deficit. In fact we had first quarter deficit of about USD 30 billion, right now we are looking at about USD 50 billion deficit for the next four months. It is not accounted by foreign direct investment (FDI) because current account deficit plus FDI and even if you include foreign portfolio investment (FPI) and equity which typically comes in unhedged, that number is almost square, is almost maybe USD 5 billion surplus. That does not amount to USD 50 billion of purchases by the RBI. So where has this dollars come in from? It is nice to see dollar reserves going up for the RBI, but it begets the question where is it coming from?
It is coming in from FPI in debt, it is coming in from exporters hedging whereas importers stay away from hedging, it comes in from people taking ECBs and not hedging. So, essentially a bulk of this move in the rupee appears to be as a direct consequence of the increase in unhedged exposures of the entire community, of the entire ecosystem, both external participants and domestic participants. To me that is not a healthy sign. A) It builds in vulnerability because if you have a global event which comes up later on, you will see a lot of this unhedged exposure suddenly turning turtle and going away and reversing, and secondly, the rupee strength which comes on the back of it, in a sense exacerbates the problem that comes along with it because you then have the point about trade deficit clearly going up this particular fiscal. You have non-oil, non-gold, everything going up in terms of imports.
So, while it is difficult to put a mathematical model around how much of imports is actually going up because of rupee, I think most of us would agree that there is a co-relation of a strong rupee and imports. So in a sense we are also making the equation a little more against us by forcing current account deficit to go up. So long story short, I don’t know what the right value of the rupee is, I don’t think anybody does, but the nature of the move dollar-rupee this particular year which seems to be on the back of a significant increase in unhedged exposure is just not healthy, and is creating conditions where current account deficit can go up even further.
Q: What I am worrying is, is there an economic problem as well already at a time when economic growth in India is not all that robust. The fact that manufactured imports will get cheaper and compete more easily with domestic manufactures, makes the growth story even more difficult, is that a proposition you agree with, is first the rupee do you agree overvalued vis-à-vis our competitors and therefore is it becoming a problem for Indian growth?
Bhargava: I think INR does look rich on a REER basis and part of it is reflecting the current account recovery through 2013 and 2014. However, like Ananth Narayan mentioned earlier, the recent rally from this year onwards is looking more stretched and while it is very difficult to judge the fair value, I think part of the reason why we have had a more subdued 64 kind of a forecast is because we think currency has run up a lot and much of it has got to do with the inflow in bonds rather than any fundamental adjustments that have happened on the ground. So it is mildly overvalued we think.
In terms of what kind of damage it has done to India exports, so if you do a regular relative competitive analysis especially versus China, some of the numbers that we have seen is that India does seem to have lost competitiveness in machinery and relatively high skilled sectors against China. I don’t think there are any alarming signs yet, but I think the gain in market share that India had which were very meaningful till about 2011-2012, have slowed down to a great extent and despite opening up of FDI in manufacturing sector, you are seeing majority of the flows still going into the services sector and the government policies have clearly not addressed the constraints which are holding back significant investment in manufacturing.
So, yes, I think that there is a bit of loss of competitiveness. It may not be clearly linked to just exchange rate because I mean there have been like ‘n’ number of models which have been run and which reflect that global demand is a bigger driver of exports than real exchange rate but there is clearly a loss of competitiveness for Indian exports.
Q: Do you not think that like Deepali Bhargava has been pointing out, in a number of machine tools and machinery imports, clearly Chinese units are having an advantage over India? Our own IIP numbers have been weak, so clearly is there not a displacement from buying from Indians to buying from maybe China and other importers, don’t you see that very obvious in some products?
Varma: Then the question is why did a 90 percent depreciation not give the same companies an advantage? If a 10 percent can put you at a disadvantage then why does the doubling of currency not give you an advantage? I think something else is at work and we need to identify those issues rather than just blaming it on the currency.
Second, is it possible that the products are such that irrespective of the currency moves, you don’t have the production capacity here? For instance I am just giving an example, let us take electronics, if you don’t have the manufacturing capacity here, but you do have a fairly robust domestic demand, then you will see demand remain strong and you will see cases of imports because domestic production capacity is not there. So it does seem that given the performance of the bilateral exchange rate between China-India and how the trade deficit has moved, that it is not just the FX alone here.
Q: Do you think the rupee can get even stronger, what is the Standard Chartered view? There are people who are even talking of 58.
Narayan: We are not that radical as yet. Who knows even the radical view might come true. We still think that rupee will remain largely stable, that is the official view at about 64 mark. There are a few factors at play here. One is the dollar continues to weaken, in fact we started the beginning of the year expecting the dollar to strengthen and continue strengthen. That clearly has belied hopes. So from a 103 dollar index, we have come down to about 93; it is almost a 10 percent move which has happened and it is possible that dollar could continue to soften in the global markets. Now if that happens, you would have reason for dollar-rupee to remain soft and continue with the current trend of remaining soft or remaining stable.
The other issue which remains is that the old point about the impossible trinity. The fact that you have an independent monetary policy which is inflation targeting does leave the market with the perception that maybe real rates in India are a bit on the higher side because of which interest rate differentials are high which has an impact on capital flows as well as on the stability of the rupee, one of the reasons why exporters are hedging so much is they perceive the forward premier which is nothing but interest rate differentials to be on the higher side compared to what they expect the depreciation to be. So, given that you might see the trend continuing.
What I am worried about though is, I still believe that a big part of this particular rupee appreciation story that we have seen so far is on the back of an increase in unhedged exposures and a substantial increase in unhedged exposures which means that the possibility of a backlash and of a reversal if you have a global risk-off is quite high. In todays market where traded volatility might be pretty low, but uncertainty still remains extremely high and it is only a tweet away from one more risk event, it is not a good situation to be in. In fact what we would recommend to our clients is to actually be cautious, take advantage of the fact that markets are very favourable, dollar-rupee is low, volatility is low, premiums have come down, and buy insurance.
While the base case is not -- we don’t expect 67-70 to happen in dollar-rupee over the next one year, who knows vulnerabilities are there, buy the insurance, participate on the downside if dollar-rupee comes down but be prepared in case you see a spike up in dollar-rupee because of global or domestic events. So that is the broad sense that we have as a bank at least.
Q: How do you think the rupee is headed for the rest of the year and how would you want policies to be designed to prevent the rupee appreciation from harming growth?
Varma: Our view more from a 6-12 month timeframe is we are positive on the Indian rupee vis-à-vis the US dollar for all the reasons that are very well known including number of pull factors for India, good growth, good reforms, FDI which is funding the current account deficit, so, we are looking for INR to appreciate marginally from current levels to about 63.8 by the end of this year and we actually have a more longer term forecast of about 62 against the US dollar by 2019.
Conversely we are more cautious on the outlook for China, growth has been stable, but we see growth slowing again after the political transition later this year. Financial debt remains very high, and we think fundamentally the pressure in China continues in the direction of capital outflows rather than capital inflows. So, we do expect the Chinese yuan to actually depreciate against the US dollar. So from that perspective and getting back to your earlier question, I think from a bilateral exchange rate perspective, the pressure on INR will be fundamentally in the direction of appreciation and we really need to sit down and think in terms of how and what should be the policy strategy to deal with the appreciation pressures that we see.
If I may just put in, the question is what should be the approach on the policy front and one is we need to prioritise capital flows so equity more than debt, long term more than short term. Second is continue to intervene to build FX reserves, sterilise the liquidity that is created as a byproduct of that and third allow a bit of appreciation.
Q: How are you looking at the course of the rupee vis-à-vis other emerging markets and as well are there really so many policy choices if you have an MPC with a given mandate of inflation control, and you have crude which looks on a secular term headed under 50 or around USD 50?
Bhargava: India carry and stability still are pretty attractive for investors. So we have a pretty bullish INR view of about 62.50 on a 12 month horizon. I think RBI was probably looking at rmb very actively for the last three to four years, but I think how the USD trades broadly will be very important in terms of how RBI manages the INR from here on. Our G10 strategist have just held their three month euro USD view at 1.19 and euro is actually run ahead of all the measures. So we are pretty bearish on US dollar like the others and hence have a bullish view on INR more from that perspective.
I think one way they could really ease the valuation constrain that India I think will face is by running a consistently lower inflation than its trading partners and that will probably be something which the monetary policy committee can focus on for the next few years. Get macro stability, inflation stability in place and that in a big way can take care of your INR overvaluation concerns.
Q: You have spoken more about financial vulnerability, we have discussed economic vulnerability with the economist, how can RBI or the policymakers tackle the potential financial vulnerability from unhedged exposures?
Narayan: Couple of ideas, one, to be honest, the RBI has already been a pioneer in applying macro prudential norms to control unhedged exposures and this was kind of a unique experiment in India where the risk-weighted assets (RWA) that banks assign to clients who don’t hedge actually goes up. It has been a matter of a lot of debate but I do see merit in that. I do see the use of macro prudential norms as being one way in which we control this particular vulnerability.
The second thing which is a little more tactical and market linked, one way in which RBI has been sterilising this excess liquidity which comes out of spot purchases is by actually buying dollars in the forward market. When they buy in the forward market, obviously the liquidity in the spot market does not come in for rupee, but concomitantly what also comes about is there is a bit of a support which comes in for forward premier in the FX markets. Now India is not a country with perfect interest rate parity. So your implied forward premium and implied interest rate differentials can be very different in the FX markets compared to the money markets.
Now one suggestion is that the RBI should maybe stay away from the FX intervention in the forwards market, therefore allow forwards to find their own natural level of demand and supply to a level where it comes down where exporters think twice before they hedge and importers are enticed to come in and start hedging more. Now clearly RBI is aware of these dynamics and it chooses between open market operation (OMO), market stabilization scheme (MSS) and the other reverse repo, etc. vis-à-vis the FX forward markets. I do think staying away from the FX forward markets would be a good option to allow a semblance of natural stability and balance to come in in the FX markets.Last bit on this whole economic fundamental situation, we can only give anecdotal evidence. I can think of several clients who are facing the pressure of import substitution or are being asked by retail houses, by other clients to reduce their prices citing that imports from China, Vietnam, etc. are becoming cheaper.