India may end up implicitly choosing a stance of preferring capital flows over current account flows, if it sets a GDP target in a foreign currency.
A currency serves two purposes: medium of exchange and store of value. We have explored this idea in these pages in a different context earlier when we looked at the relationship between legacy finance firms and fintech companies. Today, we explore the implication of this definition and purpose of a currency in the context of a country’s financial relationships with other countries.
For a country, its relationship with the world flows through two accounts: capital account and current account. For sake of simplicity, capital account refers to all the monies transferred on account of buying or selling of assets like equity, debt, property, etc, and current account includes all the trade in goods and services including investment incomes and remittances. It can readily be seen that when a country engages with the world on the current account, its currency is being used as a medium of exchange; when it interacts using the capital account, the current is a store of value.
There is a natural tension when any good has to serve two purposes. An investor looks for a more stable store of value: they would want that the value of investment changes largely due to the underlying economic factors, and not because of currency. A buyer or seller of goods and services would want a higher or lower value of the currency depending on which side of the trade s/he is: the lower the value of a currency, the easier for exporter to export and more difficult for an importer to import.
India runs a current account deficit that is made up by capital account surplus—the net result of which is that, the balance of payments tends to be marginally positive in most of the years. This shows up in the rising foreign exchange reserves of the country. Over the few decades, before it changed track in the last couple of years, China used to have large current account surpluses and not-as-large capital account deficits, and hence, they too built up very large foreign exchange reserves. Both countries operate at very different scales in their capital and current accounts, and, hence, the stock of forex reserves is very different across the two.
India’s articulated policy on its exchange rate is that it does not target any particular level, but it also does not like significant volatility. What most economic agents bake in, over medium-term time periods, is a depreciation in the Indian rupee vis-à-vis say, the US dollar. This largely follows from the inflation differential in both the economies. Before the mandate of the Monetary Policy Committee to keep inflation within the 4% +/- 2% range, Indian inflation had seen significant upticks. Over the last few years, inflation has been maintained in the defined range. However, the realised and expected inflation in the US economy has been lower than India’s. Sometimes, economic and financial forces can create sudden sharp movements in currency rates, as happened during the ‘taper-tantrum’.
If the exchange rate between the two currencies do not regularly take the inflation divergence into account, the Indian rupee can start to become uncompetitively strong from an export perspective. However, a strong currency works well from the perspective of foreign portfolio investors (FPIs) and foreign direct investors (FDI). Not articulating an exchange rate level is, therefore, an attempt at balancing these naturally-conflicting interests. It is worth reviewing periodically (every decade?) whether India wants to have a balancing stance or prefers one form of currency flow over the other (capital versus current).
The $5-tn question
A new element in this currency conundrum is the target of India becoming a $5 trillion GDP economy. The recently-released National Infrastructure Plan (NIP) has projections of the Indian economy over the next few years. It forecasts that the GDP of the Indian economy is expected to be Rs 365 trillion by FY25, which implies an ~12% compounded annual growth rate over the FY20 GDP of Rs205 trillion. At current exchange rates of ~Rs71-72 to a dollar, Rs365 trillion GDP in FY25 implies a $5 trillion economy.
The 12% nominal growth is broadly expected to be 7-8% real and 4-5% inflation. Assuming dollar inflation at 1-2%, this will imply a depreciation of 3-4% in rupees every year. Such a change may not take place every year, but the cumulative effect will possibly catch up over a five-year period. This could imply a 15-20% change in the INR-USD rate over this time period. If this happens (that the Rs/$ rate moves to say 90 over this period), then Rs365 trillion will amount to only $4 trillion GDP.
Reaching the $5-trillion-GDP target will be easier if the currency remains stable at current exchange rates. This may be possible if RBI targets and maintains a level of the currency—this will require a change in the current stance. Any such implicit or explicit move will have follow-through implications on the local economy via interest rates, inflation expectations and real-effective exchange rate of Indian rupee vis-à-vis its trade partners.
A large part of the $5 trillion GDP economy is predicated on the increase in net-exports (excess of exports minus imports): a strong rupee may not make this easy. A currency which is stable and strong will, however, be welcomed by FPI and FDI investors. With its growing market and liberal FDI policies, India will become a strong contender for increased capital flows.
India may end up implicitly choosing a stance of preferring capital flows over current account flows, if it sets a GDP target in a foreign currency: India should make this position explicit. If it wants to continue maintaining a balanced stance, reiterating its growth aspirations and GDP targets in its own currency will be useful.
The author is Head, Strategy and New Initiatives, Axis Bank. Views are personal.
Originally published in The Financial Express.