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  1. 1. India’s Trillion DollarQuestion:Is the Rising Rupee theSolution -- or the Problem?Joshua FelmanInternational Monetary FundNew Delhi
  2. 2. A disclaimer!The views expressed in this presentationare personal. They are not necessarilyshared by the IMF, its Executive Board, orits management.
  3. 3. Last week…There was a major piece of economicnewsSo important that newspapers put it onpage 1Almost overnight, while the nation wassleeping….
  4. 4. India became a trillion dollareconomyIndias Nominal GDP (US $ billion)40060080010001200 2001-022002-032003-042004-052005-062006-072007-08
  5. 5. The trillion-dollar clubThere are only 10 other countries with trillion-dollar economiesU.S.JapanGermanyChinaUnited KingdomFranceItalySpainCanadaBrazilRussiaWhile “large economy” and “rich” are not synonymous, per capitaincome will soon surpass $1,000, vaulting India into the ranks of themiddle-income countries
  6. 6. How did this happen?The arithmetic:In 2006/07, GDP was Rs 41 trillionDividing by the average exchange rate for lastyear, we get $926 billionSo, how did we get to $1 trillion already?The rupee GDP is growingWhat happened to the exchange rate?
  7. 7. Since mid-March, the exchangerate has appreciated sharplyDaily exchange rate (Rs/$)4041424344454647482-Jun-0314-Jul-0325-Aug-036-Oct-0317-Nov-0329-Dec-039-Feb-0422-Mar-043-May-0414-Jun-0426-Jul-046-Sep-0418-Oct-0429-Nov-0410-Jan-0521-Feb-054-Apr-0516-May-0527-Jun-058-Aug-0519-Sep-0531-Oct-0512-Dec-0523-Jan-066-Mar-0617-Apr-0629-May-0610-Jul-0621-Aug-062-Oct-0613-Nov-0625-Dec-065-Feb-0719-Mar-0730-Apr-07
  8. 8. Daily exchange rate movementsPercentage change in daily exchange rate (Rs/$)-3.0-2.5-2.0-1.5-1.0- +/- 2.0%
  9. 9. Roadmap of PresentationWhy is the exchange rate appreciating?The trillion-dollar question: is the risingrupee a good thing – or a problem?What are the RBI’s options?
  10. 10. Roadmap of PresentationWhy is the exchange rate appreciating?The trillion-dollar question: is the risingrupee a good thing – or a problem?What are the RBI’s options?
  11. 11. The inflation problemTo understand why the exchange rate isappreciating today, you have to go back to2006Last year, economic growth spurted to 9percent and the economy began to overheatProduction reached full capacityHousing prices soaredMost serious, inflation started to rise
  12. 12. Inflation increased sharplystarting mid-year…India: WPI Inflation Rate (seasonally adjusted)(3-month moving average of m/m percent change)AllExcluding foodand energy-0.2- 2005M6 2005M11 2006M4 2006M9 2007M2-0.2-
  13. 13. At the root of the problemSupply shortagesFood prices increased sharply because ofpoor harvests and increases in world pricesExcess demandCredit was rising rapidly – by 30 percentper year for 3 consecutive years“Too much money chasing too few goods”
  14. 14. The credit boomCredit growth (percentage change, non-food credit)12.528.417.537.030.528. 2002-03 2003-04 2004-05 2005-06 2006-07
  15. 15. To slow credit, the RBI raisedinterest ratesRepo and Reverse Repo Rates (in percent) Rate Reverse Repo Rate
  16. 16. But then somethingunexpected happened…In the past, whenever the RBI raisedinterest rates, firms borrowed less, andso spending and inflation slowedBut this time, firms merely turnedaround and borrowed from abroadCapital inflows into India surged tounprecedented levels
  17. 17. Inflows reached $6 billiona month – excluding ECBs!Foreign Capital Inflows, (US $ mn, 2006-07P)-4000-200002000400060008000Apr.MayJun.Jul.Aug.Sep.Oct.Nov.Dec.Jan.FDI Portfolio NR deposits
  18. 18. …while ECBs reached $4 billionper quarterCommercial borrowings from abroad(US $ million)-5000-4000-3000-2000-1000010002000300040005000Jun-04Aug-04Oct-04Dec-04Feb-05Apr-05Jun-05Aug-05Oct-05Dec-05Feb-06Apr-06Jun-06Aug-06Oct-06Dec-06
  19. 19. The RBI responded byintervening…Foreign exchange purchases (US $ billion) Nov-06 Dec-06 Jan-07 Feb-07
  20. 20. …which inflated the moneysupplyReserve money increase (Rs billion)3333738222309144811255231760100200300400500600Nov-06 Dec-06 Jan-07 Feb-07 Mar-07Incremental reserve moneyForex purchases
  21. 21. The “impossible trinity”The RBI had just fallen victim to the“impossible trinity”Not possible to simultaneously:Target interest ratesTarget the exchange rateMaintain an open capital accountPreviously, this was not a problemCapital account was tightly controlledWhat changed?
  22. 22. India is globalizing rapidlyThe statistics on India’s financial integrationwith the rest of the world are astonishing:Total two-way gross flows on balance of paymentstransactions were $101 billion in 1992/93They were $237 billion in 2001/02And $657 billion in 2005/06In other words:Doubling took nine yearsNear-tripling took only four
  23. 23. India’s globalizationMore statistics:External flows were 47 percent of GDP in 1992/93And 91 percent of GDP in 2005/06.This tremendous flow of funds across India’sborders is rapidly eroding the country’scapital controlsThe “impossible trinity” is beginning to bite
  24. 24. How should the RBI respond?Two options:Do somethingDo nothingThe appropriate response depends onwhether rupee appreciation is good forthe economy, or notOnce we have answered the question,we can consider the RBI’s options
  25. 25. Roadmap of PresentationWhy is the exchange rate appreciating?The trillion-dollar question: is the risingrupee a good thing – or a problem?What are the RBI’s options?
  26. 26. Advantages of rupeeappreciationAs we have seen, appreciation makes India richer:rupee assets are worth more in dollarsAlso, a strong rupee helps reduce inflationLowers import prices, notably for oil, other raw materials,and capital goods, lowering the cost of productionIt also reduces the prices of import-competing products, likesteelSo, a strong rupee helps consumers
  27. 27. Disadvantages of rupeeappreciationA stronger rupee hurts exportersExport earnings are worth less in rupeesThough this is partly offset by lower input costsAlso, to the extent that a stronger rupee relievesinflationary pressure, it reduces the need forinterest rate increasesStill, on balance, export profitability islikely to suffer and exports may slow
  28. 28. Significance testHow to balance these considerations?Obviously, difficult to balance consumersand producersPerhaps the issue can be side-steppedIs the appreciation significant?Small appreciation = minor issueTo assess this, cannot just look at therupee/dollar rate, because India exports tomany countries
  29. 29. Appreciation against the Eurohas been much smaller
  30. 30. Measuring the “real exchangerate”To get a comprehensive picture, we average thevarious exchange rates, weighted by exports todifferent countriesThis is called the nominal effective exchange rate(NEER)Then the NEER is adjusted by differences in inflation,because if a country has appreciated in nominalterms because its inflation is lower, then it hasn’t lostany real competitivenessThis adjusted rate is called the real effectiveexchange rate (REER)
  31. 31. How has the REER moved?Through January – before the recentsharp appreciation – the NEER hadactually been depreciatingBut inflation has been higher than inother countriesSo, the REER has been rising, implyinga slight loss in competitiveness
  32. 32. Until January, the REERappreciation has been modest.REER IMFRevisedNEERRelative CPI0204060801001201401602000Jan2000Jul2001Jan2001Jul2002Jan2002Jul2003Jan2003Jul2004Jan2004Jul2005Jan2005Jul2006Jan2006Jul2007JanFigure II.5. CPI Based Real Effective Exchange Rate and Its Components(1993=100)
  33. 33. India’s appreciation has beenamongst the smallest in Asia-8 -4 0 4 8 12Hong Kong SARIndiaSingaporeChinaKoreaMalaysiaIndonesiaPhilippinesThailandSource: IMF, INS database.Real Effective Exchange Rates(Percent changes, January 2006-January 2007)AppreciationDepreciation
  34. 34. But the appreciation sinceJanuary has been significantExchange rate has appreciated by 7percent against the dollar and 4½percent against the euroSo, the REER is probably around 10percent higher than its 1993/94 “base”
  35. 35. How would this appreciationaffect exporters?Depends on the existing level ofprofitabilityIf corporate profitability high, then amoderate appreciation will notmaterially change their competitivenessBut if profits are low, there could bedifficultiesWhat is the current situation?
  36. 36. Overall, corporate profitabilityis exceptionally high10.311.111.914.515.66810121416182002-03 2003-04 2004-05 2005-06 H1 2006-07 H1Gross profits to sales, RBI Bulletin
  37. 37. More recent dataAnalysis of October-December 2006quarterly results of 808 companies(Business Standard) showed a:67 per cent increase in net profits, and35 per cent increase in net sales.January-March results are still coming in,but they show a similar story
  38. 38. Exporters have been gainingglobal market shareIVIIIVIIIVIIIVIIIVIIIVII2006200520042003200220011. of Global Exports of Goodsindbp02g(In percent)
  39. 39. …but the appreciation could hurtsome labor-intensive sectors
  40. 40. To summarizeWeighing the advantages anddisadvantages is difficultRBI’s (and public’s) priority now iscontrolling inflationBut the REER appreciation is significant,and could hurt some key sectorsWhat are the RBI’s options?
  41. 41. Roadmap of PresentationWhy is the exchange rate appreciating?The trillion-dollar question: is the risingrupee a good thing – or a problem?What are the RBI’s options?
  42. 42. Sterilization: the first line ofdefenceGo back to the earlier problem: interventionto defend the exchange rate fueled anunwanted increase in the money supplyIs there any way to prevent this moneysupply increase?Yes! It’s called “sterilization”RBI can buy up the excess rupees by issuingbonds (MSS)Or it can force banks to deposit these rupees atthe central bank, so they can’t lend them out(CRR)
  43. 43. In fact, the RBI has issued MSSbonds…Outstanding MSS (Rs billion, 2006-07)0100200300400500600700800SeptemberOctoberNovemberDecemberJanuaryFebruaryMarchAprilData for April upto 20 only
  44. 44. …and it has increased the CRRReserve Requirements4. Dec 6th Jan. 17th Feb. 3rd Mar. 14th April 28th April
  45. 45. … moderating the increase inreserve moneyReserve money growth (percent)14%16%18%20%22%24%26%28%Nov-06 Dec-06 Jan-07 Feb-07 Mar-07ActualImplied
  46. 46. So, does sterilization solve theproblem?Not really!Sterilization creates problems of its own
  47. 47. Problems with CRR increasesA tax on the banking system, as banks areforced to place funds in non-interest bearingaccounts, rather than loan them outImposes a large and disruptive shock to thesystem: all banks are forced to come up withfunds to deposit at the RBINot a problem for those which brought in foreignexchange and now have excess rupees.But what about the others?
  48. 48. Problems with MSSMSS is less disruptive and more market-friendly, since bonds will be bought (only) bybanks with excess fundsBut then the government has to pay intereston the bonds, potentially foreverThe interest costs mount with each dollar ofinterventionThis spending could be put to other uses,such as building roads, hospitals, and schools
  49. 49. Cost of sterilizationThe annual “carrying cost” of theDecember-February intervention isabout Rs 25 billionIf intervention continued at this rate foranother three months, the annual costwould be Rs 50 billionIf it continued for a year, the annualcost would be Rs 100 billion!
  50. 50. How does China do it?After all, China has intervened muchmore than IndiaThey have kept their exchange ratevery stable against the dollar, amassinghuge amounts of reserves, whilekeeping reserve money growth belowIndia’s level!
  51. 51. Foreign exchange reserves crossed atrillion dollars in 2006China: Official reserves and Reserve money growth.0200400600800100012002001 2002 2003 2004 2005 20060. exchange reserves (US $ billion) Reserve money growth
  52. 52. Do they have a specialtechnique of sterilization?Not really. They also sell bonds andincrease the CRRKey difference: Chinese interest ratesare much lower.
  53. 53. China actually earns more on its reservesthan it pays on its sterilization bondsInterest differential on Chinese and US securitiesChina (3 mth centralbank bill rate)US (10 year treasurynote yield)01234567Jan-00May-00Sep-00Jan-01May-01Sep-01Jan-02May-02Sep-02Jan-03May-03Sep-03Jan-04May-04Sep-04Jan-05May-05Sep-05Jan-06May-06Sep-06Jan-07
  54. 54. But there are hidden costsChinese interest rates are low partly becausethey control the banking sectorThey force banks to accept low interest ratesand make loans to public enterprisesThen they recapitalize the banks when theymake losses. Recapitalization has cost billionsof dollars.
  55. 55. Also, intervention andsterilization create market risksInterest rate riskIMF calculations in 2004 showed that a 100 bps increase inU.S./Euro bond yields would reduce the capital value ofChina’s foreign bond holdings by 10 percent, implying acapital loss of 2 percent of GDPNow, reserves are roughly twice as largeCurrency riskAlso, each additional $100 billion in reserves would implylosses of 2/3 percent of GDP if the exchange rateappreciated by 10 percent
  56. 56. ImplicationsA sterilization policy would be costly and riskyfor IndiaSo, it may not be sustainableIf not, it could be disruptive when the policyis abandonedIn that case, it might be better not to embarkon a policy of “guaranteeing” the exchangerate in the first placeFirms could still hedge their exchange rate risk inthe forward market
  57. 57. This reasoning led the RBI tostop defending the exchangerate in mid-MarchDaily exchange rate (Rs/$)4041424344454647482-Jun-0314-Jul-0325-Aug-036-Oct-0317-Nov-0329-Dec-039-Feb-0422-Mar-043-May-0414-Jun-0426-Jul-046-Sep-0418-Oct-0429-Nov-0410-Jan-0521-Feb-054-Apr-0516-May-0527-Jun-058-Aug-0519-Sep-0531-Oct-0512-Dec-0523-Jan-066-Mar-0617-Apr-0629-May-0610-Jul-0621-Aug-062-Oct-0613-Nov-0625-Dec-065-Feb-0719-Mar-0730-Apr-07
  58. 58. Any other options?
  59. 59. The second line of defense:capital account regulationsSome small steps have already been take to discourageinflows:Reinterpretation of pre-IPO capital inflows in real estate sector, todisqualify them as FII investmentBut major changes would be difficultNow that India is so highly integrated with the rest of the world,major capital account restrictions would be highly disruptiveIt would also send a damaging signal to the business communitythat even fundamental reforms can be reversedEarlier this year, Thailand imposed some partial capital controlsThe stock market fell 15 percent on the first day, forcing theauthorities to repeal many of the measures
  60. 60. Capital account regulations/2A more promising alternative would be toliberalize some of the remaining controls onoutflowsThe RBI has been doing this, raising overseasinvestment limits:For individuals, to $50,000 (October) and then$1,00,000 (April)For companies, to 300 percent of net worth.For mutual funds, to $3 bn (October) and then $4bn (April)
  61. 61. ConclusionIndia is now living in a Brave New World, a globalized one,where the old policy approaches may no longer applyIn particular, one of the problems of success is that India isattracting large capital inflowsDealing with these inflows is difficult; no country has found themagic solutionIntervening to defend the exchange rate can help preserveexport competitiveness, but it can endanger the inflation targetSterilization can “square the circle”, but is costly and ultimatelynot sustainableLiberalizing capital inflows is one possibility, but it is not acomplete solutionSo, the Reserve Bank has some difficult choices to make
  62. 62. What would you do?
  63. 63. Also, competitiveness is not justa matter of the exchange rateThe REER has been rising since 2002But exports of goods and services haveroughly tripledAnd profits soared
  64. 64. How did this happen?Many explanationsCustoms duties were reducedCapital controls were relaxedTransport and communicationsinfrastructure improvedIn short, India developed, and as thisoccurs REERs naturally tend to rise
  65. 65. Exporting is not an endIt is a means to achieving competitivefirmsIt is this process that generates growth