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The speed of the appreciation of the rupee against the dollar has been a major cause of concern to policymakers. As of October, the rupee had appreciated close to 13 per cent on a year-on-year basis against the greenback.
Nearly 7.5 per cent of this appreciation came in the months of April and May. In recent months, net FII inflows have picked up - around $5.7 billion in October itself. The recent cuts in the Fed rate are likely to provide a further impetus to the inflows and put more pressure on the rupee. One of the major worries of rupee appreciation is the hit exports are expected to take.
Exports growth has slowed down recently as compared to the previous years with the currency appreciation shouldering the blame. No doubt there will be some temporary negative effect.
But the real question is whether this represents a permanent change in export performance or a temporary effect, which will be offset over time by product and destination diversification, increased productivity and the fact that an appreciated currency makes imports, many of which go into exports, relatively cheap, allowing exporters to reduce price and improve volumes. We do not deal here with the latter issue which will be dealt with in a subsequent article.
To begin with, let us look at a straight-forward question. Given that the expansion of international trade has been a prominent feature of Indian economy in recent years, what has been its contribution to economic growth? Both export and import growth has averaged over 30 per cent in the last three years. Nonetheless, in nominal terms imports continue to be greater than exports resulting in trade deficit.
It is, therefore, perceived that trade on the net basis drains income out of the country. Indeed, this was the case until the 1990s when, both in the nominal and real terms, the contribution of trade to GDP was negative. But the trend has altered significantly since then.
The figure depicts what has been the (net) contribution of foreign trade to the GDP since the 1980s. For the first time after two decades, exports made a positive contribution to real GDP in the early part of the current decade, although in nominal terms, trade deficit continued.
The largest positive contribution of net exports to the GDP came in FY06, when it stood at 1.54 per cent of the GDP. However, in the first quarter of the current financial year (2007-08), the external sector was a drain on the GDP (-1 per cent) for the first time in fourteen quarters, as exports slowed down considerably in rupee terms. Not only higher imports but also poorer exports were to blame for net exports deterioration.
The fact that there is a significant difference between net trade in nominal and real terms implies that import prices have risen faster than the appreciation of the currency. Between 2000-01 and 2005-06, while export prices grew at 7 per cent per annum, import prices grew at 15 per cent per year.
The rising prices of oil and commodities are significantly responsible for the widening gap between imports and exports in the nominal term. Going forward, the extent of appreciation of the rupee and of crude prices will shape trade deficit in FY08 and the contribution of international trade to the GDP pie.
According to the standard economic theory, other things remaining constant, an appreciation in the exchange rate augments the purchasing power of the domestic currency, in particular, the price levels in the trading countries.
This, in turn, makes imported goods cheaper but raises the value of export goods. In effect, an exchange rate appreciation hurts exports and encourages imports. This compels exporters to reduce profit margins in order to maintain their competitiveness in the world export market.
Nevertheless, the fact remains that in the last few years during which the rupee has appreciated, Indian exports of goods and services have surged ahead at a healthy rate. In fact, the correlation between the exchange rate and exports in different sectors has diminished over the last decade, even more so in the last couple of years.
This is true for some other competing Asian countries as well. For instance, although the Korean won appreciated by nearly 22 per cent from 2003 to 2006, exports growth surged at 20 per cent per year. This uneven response to rupee appreciation and continuous surge in exports can be explained by a combination of many factors.
Improvement in productivity is one of the ways by which competitiveness can be maintained when the exchange rate appreciates. Indeed, in recent years the services sector has raised its productivity (as measured by the share of value added in sales) continuously.
Also, manufacturing productivity is on the rise once again. Since, in the medium to long run, competitiveness stems from productivity enhancements, a rise in the nominal exchange rate is less of a concern if overall competitiveness is improving due to higher product innovation and labour productivity growth.
Product and market diversification also help spread the risk related to currency appreciation. India has been moving away from traditional exports towards value-added products and services.
Service sector exports now account for over a third of total exports from India, an increase of almost 10 percentage points in just seven years. Further, compared to the early part of the 1990s the composition of India's manufacturing exports has changed as well.
The share of India's traditional manufactured exports, such as textiles and gems and jewellery, in the total exports of manufactures has declined, while that of chemicals and engineering goods has risen sharply.
Furthermore, over the last few years India's trade partners also have changed significantly and intra-Asia exports has expanded rapidly.
So, does the appreciation of the rupee against the dollar hurt export growth? Not necessarily, since a negative impact of the appreciation can be neutralised by other variables that affect exporters' earnings.
While the recent appreciation of the nominal exchange rate could lead to a reduction in exporters' revenues in rupee terms and hence, the profits margin in the short run, improved productivity and diversification can compensate the negative effect of the appreciation of the exchange rate.
And if this is the case, the rising rupee need not be a great cause for worry.
The authors are economists at CRISIL
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