The real world is often drastically different from the abstract assumptions of economic textbooks. The argument for currency depreciation leading to an improvement in trade balance assumes price elasticity of imports and exports.
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The rupee on Tuesday breached the historic low of 70-mark against the US dollar before recovering at close on suspected RBI intervention and the finance ministry’s dismissing the concerns over its sharp fall.
In the abstract world of economics textbooks, a depreciating currency need not always be a bad thing. Currency depreciation can help countries improve their trade balance. An example can help us understand this. Let us assume Indians imported only iPhones and exported only shirts.
A fall in the rupee would make our imports more expensive, because Indians would be paying more in rupee terms for the unchanged dollar price of the iPhone. This would lead to a reduction in demand for iPhones and hence reduce our import bill. Similarly, an American retailer importing shirts from India would be able to get more shirts for the same expenditure in dollars. This would make him reroute more of his orders to India and lead to a rise in exports. An increase in net exports means an increase in economic growth.
The preceding discussion raises questions on the validity of alarmist commentary every time the rupee reaches a new low vis-à-vis the dollar. Are such reactions driven more by warped notions of economic nationalism than actual economic interests? Not necessarily.
The real world is often drastically different from the abstract assumptions of economic textbooks. The argument for currency depreciation leading to an improvement in trade balance assumes price elasticity of imports and exports. In simple terms, a commodity is described as price elastic if its demand is responsive to a change in price.
One of India’s biggest imports is crude oil. An economy cannot adjust its petroleum consumption with change in prices. Energy requirements are driven by level of activity and wealth in an economy. Herein lays perhaps the most important cost of a falling rupee for India. A fall in the rupee means a rise in price of India’s crude oil basket (COB). This implies a rise in fiscal deficit and inflation.
A rapidly depreciating currency also deprives the economy from exploiting the gains of fall in international oil prices. Chart 1 shows the annual change in prices of India’s COB in dollar and rupee terms. In 12 out of 18 years since 2001-02, the change in the rupee price of India’s COB has been unfavourable vis-à-vis the dollar price. This means that when oil prices have fallen, the rupee price has fallen less than the dollar price and when prices have risen, the rupee price has risen more than the dollar price. A bigger fall in the rupee at a time of rising oil prices is bound to increase this pain.
It could be argued that the logic of depreciation being beneficial applies to other sectors of the economy. Our non-petroleum trade balance could improve. Non Resident Indians (NRIs) could be sending more money in remittances because every dollar gets much more in rupee terms. Unfortunately, the argument does not lend itself to a simple empirical scrutiny.
Chart 2 plots movements in India’s non-petroleum trade balance and current account balance with the rupee-dollar exchange rate. It does not show an improvement in trade/current account performance with a depreciating currency.
To be sure, a multitude of factors apart from exchange rates affect trade and current account balance. This is even truer in today’s age when the multilateral trading system is in serious jeopardy and world’s two largest economies, the US and China, are heading towards a full-fledged trade war.
Also, exchange rates themselves are driven by factors which are hardly in control of governments and central banks even in the biggest economies. For example, if the US were to raise its domestic interest rates tomorrow, dollar deposits from across the world are likely to head back home. This is bound to generate headwinds for domestic currency in countries where they are parked currently.
The short point is, any attempts to trivialise the costs of falling rupee are unjustifiable. What is also true is the fact that there are no easy and quick solutions to such problems.
