As we’ve seen since March 2020, whenever foreign money via REIT flows into the economy, the external value of INR skyrockets despite the RBI’s valiant efforts to clean up dollar inflows. . These excessive dollar flows have a negative impact on the profitability of the export sectors and hamper the growth of export volumes.
In short, the very act of borrowing to strengthen our reserves creates an overvaluation of INR which hurts exports and leaves the underlying trade deficit uncorrected. We must disrupt this vicious loop in order to prevent our borrowing from inflating the external value of the INR.
WHY ARE EXPORTS AN OPPORTUNITY? : Global trade is recovering much faster than the Indian economy because we have messed up the management of the pandemic. We can turn this into an opportunity by adjusting the external INR value by around 20% to correct for the overvaluation that has crept into the rupee over the past decade. This will have a cascading effect on the economy, preparing it for faster growth, as briefly described below.
1. The 20% depreciation of the INR will greatly encourage exports of cereals, cotton, cotton and synthetic textiles, engineering products, automobiles and software services by making them more profitable. All of these sectors are labor intensive. As long as we maintain a consistent exchange rate policy that prevents capital flows from inflating the rupee, there is no reason that exports cannot increase by 15-20% per year.
2. The software services sector, highly labor intensive, with fabulous added value compared to manufacturing, and being less resource intensive to get started, is already profitable enough. With the depreciation of the rupee, its profitability will increase. So it may be to recover the windfall profits of the sector on the depreciation of the rupee in remove all tax exemptions and liquidate the MAT, and place the sector under a normal tax regime for exports which charges 15% of taxable profits as taxes.
3. The depreciation of the rupee can be used to liquidate most of the protectionist import duties levied on commodities like steel, cement, etc. because the depreciation itself will provide sufficient protection against imports. This should be accompanied by a firm commitment to use the exchange value of INR as a means of ensuring the profitability of exports and protection against predatory imports in all sectors on an ongoing and sustained basis.
4. Modi has piled up import duties on consumer goods. These can be canceled because the exchange value will provide protection against imports. Govt. should also institute system-wide studies to ensure that no duty reversals occur in manufacturing. Each such inversion should be removed by adjusting the external INR value within reasonable parameters.
GOVERNMENT DEBT AND SOCIAL EXPENDITURE
1. An indirect impact of the 20% INR depreciation will be to reduce the real value of the government’s domestic debt by about 18%, since this debt now represents 90% of GDP. This happens because the face value of GDP increases due to the depreciation of the INR, while the face value of the existing debt stock remains constant. The effect is not instantaneous. It takes 1 to 2 years for nominal GDP growth to feed into the economy. However, the net result is that, all other things being equal, the stock of public debt will be reduced from 90% of GDP to around 74% of GDP in about two years. This decrease in the real value of outstanding debt creates fiscal space for the additional social spending needed to revive the economy.
2. Additional tax room created will fill the 10% hole in the budget balance created by the pandemic, and still leave room for a fiscal stimulus of around 6% of GDP without taking into account the savings to come from the end of export subsidies, etc. This can be spread over the next two years.
3. Social spending should be fully oriented towards the rural sector of the economy by combining the MNREGA with rural housing, rural road construction, rural water supply systems, rural sanitation and rural primary health centers. These offer large leaps in productivity, cost little, are labor-intensive, and create semi-skilled rural jobs for wage earners, whose full income is largely spent immediately. This massive investment in the rural hinterland will help jump-start the engines of growth much better than spending money on long-gestating, capital-intensive projects like rail corridors and high-speed trains.
4. The 20% depreciation of the INR will of course hurt the holders of fixed income securities like banks, pension funds, insurance companies and some holders of term deposits. They’ve been partying since 2014, artificially enjoying huge capital gains on fixed debt securities generated by an artificially inflated rupee. Some of these gains will reverse and help dissolve some of the government’s outstanding debt.
IS THERE ANOTHER WAY?
We have come to the end of the road when it comes to borrowing internally to finance growth. We need to reduce the real value of debt in the economy to a reasonable level and, at the same time, create an opportunity for future growth through export growth, which we have neglected for too long.