Weak rupee good for current account, but immediate benefits for exports not certain..................................................................................................................Once upon a time, all countries in the world were on some kind of precious metal standard, say, gold. The currency was then backed up by gold. Let’s say there are only 2 countries in the world, India and USA. And India has a balance of trade deficit with USA. That balance of trade deficit has to be met, by India sending off some gold to USA. So there’s less gold in India and more gold in USA. The money supply in India comes down, while that in USA goes up. Prices in India come down, while those in USA go up. Indian exports to USA become more competitive, while US exports to India become less competitive. This tends to eliminate the balance of trade (BOT) deficit one started off with. There is an inbuilt mechanism that eliminates the disequilibrium. This is an artificial example, but such inbuilt mechanisms do exist. The balance of payments (BOP) doesn’t consist only of the trade (or merchandise exports/imports of goods) account. To the trade account are added net invisibles to get the current account. To the current account are added capital account transactions to get the overall BOP. The demand and supply of foreign exchange are determined both by the current account and the capital account working together. If the supply of dollars is lower than the demand for dollars, in a flexible exchange rate system (under fixed exchange rates, the exchange rate is administered by the Central Bank), the price of dollars vis-à-vis the Indian rupee will increase and the rupee will depreciate. (Devaluation is under a fixed exchange rate mechanism.) Unfortunately, forces sometimes work in different directions. India may have a higher inflation rate than USA. For Indian exports of goods and services to remain competitive vis-à-vis US products, one would want the rupee to depreciate. This is a normative argument. Exchange rates don’t necessarily work in this way, because of the capital account. For example, if interest rates in India are higher than in USA, net capital inflows may negate the underlying desire that the rupee should depreciate. But sticking to the current account, there is, in principle, a self-correcting mechanism. When the rupee depreciates, Indian exports of goods and services become more competitive. US imports become less competitive. Ipso facto, the current account deficit tends to be eliminated. Hence, most economists have welcomed the recent depreciation and sometimes, also argue in favour of an under-valued currency, because it stimulates exports. There is a catch though. The exchange rate is a price. As is evident to a non-economist too, the effect of a change in price on demand (either exports or imports) depends on the price elasticity of demand. The specialist economist will have heard of something called the Marshall-Lerner condition, which gives conditions (depending on elasticity of demand for imports and exports) under which a depreciation (or devaluation) improves the balance of trade (by extension, the current account too). Are India’s imports and exports price elastic or not? This becomes an empirical, rather than a theoretical, question. From studies that have been done, we know India’s imports are fairly price inelastic, on an average. Depreciation doesn’t reduce the quantity of imports. It makes them more expensive in rupee terms. Exports are fairly price elastic, because on an average, India is still in low value and price sensitive segments. Therefore, consequent to depreciation, both the volume and quantity of exports increases.` The Marshall-Lerner conditions are typically satisfied for India. But there is an additional catch, referred to as the J-curve effect. Exports don’t increase immediately. Present supply contracts have already been done, say, for the next 6 months. Often, when there is a depreciation, importers in those other countries ask for contracts to be re-negotiated. Even if there is a greater demand for India’s exports, because they have become cheaper, the supply-side changes need to happen. The J-curve refers to the shape of the curve, plotting the balance of trade along the Y-axis and time along the X-axis. Initially, because of those time-lags, the BOT actually worsens, the dipping part of the J. It is only beyond a period of time that the BOT improves, the increasing part of the J. How long does the dip last? That’s again an empirical question. Empirical work, both for India and other countries, suggests that the dip lasts for 18 months to 2 years. In other words, for 18 months to 2 years, there is actually a worsening of BOT. Let’s complicate matters a bit more. I have talked about the Marshall-Lerner condition. Those who specialize in international trade theory know about something called the Bickerdike-Robison-Metzler condition, a generalization, so to speak, of the Marshall-Lerner condition. The Marshall-Lerner condition is about demand alone. The Bickerdike-Robinson-Metzler condition brings in elasticity of supply, both of India’s exports and of US exports. Because this is much more messy to estimate, not too many people tend to estimate the supply elasticities, certainly not for India. The point however, is that before mechanically talking about import and export demand elasticities, one needs to recognize there are severe supply-constraints plaguing Indian manufacturing and until these are eased, there is no guarantee depreciation will help, J-curve or not. Four other points. First, the critical point is not US-rupee exchange rates, but rupee depreciation vis-à-vis India’s competitors. Indeed, it is the case that in the present cycle, the rupee has depreciated vis-à-vis these competitors. Second, exports have an import component. While exports become more competitive, imports become more expensive too. Empirically, for manufacturing, the threshold is around 45%. An enterprise benefits from depreciation if its import intensity is less than 45% and gets hurt if its import intensity is more than 45%. Third, since all this also has to do with expectations, we don’t yet know where the rupee will stabilize. And fourth, net capital inflows will mess up the picture.
Posted on: Sun, 27 Oct 2013 15:27:40 +0000
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