157-INDIA'S TRILLION DOLLAR QUESTION (Interesting)

1. India’s Trillion Dollar
Question:
Is the Rising Rupee the
Solution -- or the Problem?
Joshua Felman
International Monetary Fund
New Delhi

2. A disclaimer!
The views expressed in this presentation
are personal. They are not necessarily
shared by the IMF, its Executive Board, or
its management.

3. Last week…
There was a major piece of economic
news
So important that newspapers put it on
page 1
Almost overnight, while the nation was
sleeping….

4. India became a trillion dollar
economy
India's Nominal GDP (US $ billion)
400
600
800
1000
1200 2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08

5. The trillion-dollar club
There are only 10 other countries with trillion-dollar economies
U.S.
Japan
Germany
China
United Kingdom
France
Italy
Spain
Canada
Brazil
Russia
While “large economy” and “rich” are not synonymous, per capita
income will soon surpass $1,000, vaulting India into the ranks of the
middle-income countries

6. How did this happen?
The arithmetic:
In 2006/07, GDP was Rs 41 trillion
Dividing by the average exchange rate for last
year, we get $926 billion
So, how did we get to $1 trillion already?
The rupee GDP is growing
What happened to the exchange rate?

7. Since mid-March, the exchange
rate has appreciated sharply
Daily exchange rate (Rs/$)
40
41
42
43
44
45
46
47
48
2-Jun-03
14-Jul-03
25-Aug-03
6-Oct-03
17-Nov-03
29-Dec-03
9-Feb-04
22-Mar-04
3-May-04
14-Jun-04
26-Jul-04
6-Sep-04
18-Oct-04
29-Nov-04
10-Jan-05
21-Feb-05
4-Apr-05
16-May-05
27-Jun-05
8-Aug-05
19-Sep-05
31-Oct-05
12-Dec-05
23-Jan-06
6-Mar-06
17-Apr-06
29-May-06
10-Jul-06
21-Aug-06
2-Oct-06
13-Nov-06
25-Dec-06
5-Feb-07
19-Mar-07
30-Apr-07

8. Daily exchange rate movements
Percentage change in daily exchange rate (Rs/$)
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Volatility +/- 2.0%

9. Roadmap of Presentation
Why is the exchange rate appreciating?
The trillion-dollar question: is the rising
rupee a good thing – or a problem?
What are the RBI’s options?

10. Roadmap of Presentation
Why is the exchange rate appreciating?
The trillion-dollar question: is the rising
rupee a good thing – or a problem?
What are the RBI’s options?

11. The inflation problem
To understand why the exchange rate is
appreciating today, you have to go back to
2006
Last year, economic growth spurted to 9
percent and the economy began to overheat
Production reached full capacity
Housing prices soared
Most serious, inflation started to rise

12. Inflation increased sharply
starting mid-year…
India: WPI Inflation Rate (seasonally adjusted)
(3-month moving average of m/m percent change)
All
Excluding food
and energy
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2005M1 2005M6 2005M11 2006M4 2006M9 2007M2
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

13. At the root of the problem
Supply shortages
Food prices increased sharply because of
poor harvests and increases in world prices
Excess demand
Credit was rising rapidly – by 30 percent
per year for 3 consecutive years
“Too much money chasing too few goods”

14. The credit boom
Credit growth (percentage change, non-food credit)
12.5
28.4
17.5
37.0
30.5
28.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

15. To slow credit, the RBI raised
interest rates
Repo and Reverse Repo Rates (in percent)
5.0
6.0
7.0
8.0
9.0
10.0
Repo Rate Reverse Repo Rate

16. But then something
unexpected happened…
In the past, whenever the RBI raised
interest rates, firms borrowed less, and
so spending and inflation slowed
But this time, firms merely turned
around and borrowed from abroad
Capital inflows into India surged to
unprecedented levels

17. Inflows reached $6 billion
a month – excluding ECBs!
Foreign Capital Inflows, (US $ mn, 2006-07P)
-4000
-2000
0
2000
4000
6000
8000
Apr.
May
Jun.
Jul.
Aug.
Sep.
Oct.
Nov.
Dec.
Jan.
FDI Portfolio NR deposits

18. …while ECBs reached $4 billion
per quarter
Commercial borrowings from abroad
(US $ million)
-5000
-4000
-3000
-2000
-1000
0
1000
2000
3000
4000
5000
Jun-04
Aug-04
Oct-04
Dec-04
Feb-05
Apr-05
Jun-05
Aug-05
Oct-05
Dec-05
Feb-06
Apr-06
Jun-06
Aug-06
Oct-06
Dec-06

19. The RBI responded by
intervening…
Foreign exchange purchases (US $ billion)
0.0
3.2
1.8
2.8
11.9
0
2
4
6
8
10
12
14
Oct-06 Nov-06 Dec-06 Jan-07 Feb-07

20. …which inflated the money
supply
Reserve money increase (Rs billion)
33
337
38
222
309
144
81
125
523
176
0
100
200
300
400
500
600
Nov-06 Dec-06 Jan-07 Feb-07 Mar-07
Incremental reserve money
Forex purchases

21. The “impossible trinity”
The RBI had just fallen victim to the
“impossible trinity”
Not possible to simultaneously:
Target interest rates
Target the exchange rate
Maintain an open capital account
Previously, this was not a problem
Capital account was tightly controlled
What changed?

22. India is globalizing rapidly
The statistics on India’s financial integration
with the rest of the world are astonishing:
Total two-way gross flows on balance of payments
transactions were $101 billion in 1992/93
They were $237 billion in 2001/02
And $657 billion in 2005/06
In other words:
Doubling took nine years
Near-tripling took only four

23. India’s globalization
More statistics:
External flows were 47 percent of GDP in 1992/93
And 91 percent of GDP in 2005/06.
This tremendous flow of funds across India’s
borders is rapidly eroding the country’s
capital controls
The “impossible trinity” is beginning to bite

24. How should the RBI respond?
Two options:
Do something
Do nothing
The appropriate response depends on
whether rupee appreciation is good for
the economy, or not
Once we have answered the question,
we can consider the RBI’s options

25. Roadmap of Presentation
Why is the exchange rate appreciating?
The trillion-dollar question: is the rising
rupee a good thing – or a problem?
What are the RBI’s options?

26. Advantages of rupee
appreciation
As we have seen, appreciation makes India richer:
rupee assets are worth more in dollars
Also, a strong rupee helps reduce inflation
Lowers import prices, notably for oil, other raw materials,
and capital goods, lowering the cost of production
It also reduces the prices of import-competing products, like
steel
So, a strong rupee helps consumers

27. Disadvantages of rupee
appreciation
A stronger rupee hurts exporters
Export earnings are worth less in rupees
Though this is partly offset by lower input costs
Also, to the extent that a stronger rupee relieves
inflationary pressure, it reduces the need for
interest rate increases
Still, on balance, export profitability is
likely to suffer and exports may slow

28. Significance test
How to balance these considerations?
Obviously, difficult to balance consumers
and producers
Perhaps the issue can be side-stepped
Is the appreciation significant?
Small appreciation = minor issue
To assess this, cannot just look at the
rupee/dollar rate, because India exports to
many countries

29. Appreciation against the Euro
has been much smaller

30. Measuring the “real exchange
rate”
To get a comprehensive picture, we average the
various exchange rates, weighted by exports to
different countries
This is called the nominal effective exchange rate
(NEER)
Then the NEER is adjusted by differences in inflation,
because if a country has appreciated in nominal
terms because its inflation is lower, then it hasn’t lost
any real competitiveness
This adjusted rate is called the real effective
exchange rate (REER)

31. How has the REER moved?
Through January – before the recent
sharp appreciation – the NEER had
actually been depreciating
But inflation has been higher than in
other countries
So, the REER has been rising, implying
a slight loss in competitiveness

32. Until January, the REER
appreciation has been modest
.
REER IMF
Revised
NEER
Relative CPI
0
20
40
60
80
100
120
140
160
2000Jan
2000Jul
2001Jan
2001Jul
2002Jan
2002Jul
2003Jan
2003Jul
2004Jan
2004Jul
2005Jan
2005Jul
2006Jan
2006Jul
2007Jan
Figure II.5. CPI Based Real Effective Exchange Rate and Its Components
(1993=100)

33. India’s appreciation has been
amongst the smallest in Asia
-8 -4 0 4 8 12
Hong Kong SAR
India
Singapore
China
Korea
Malaysia
Indonesia
Philippines
Thailand
Source: IMF, INS database.
Real Effective Exchange Rates
(Percent changes, January 2006-January 2007)
AppreciationDepreciation

34. But the appreciation since
January has been significant
Exchange rate has appreciated by 7
percent against the dollar and 4½
percent against the euro
So, the REER is probably around 10
percent higher than its 1993/94 “base”

35. How would this appreciation
affect exporters?
Depends on the existing level of
profitability
If corporate profitability high, then a
moderate appreciation will not
materially change their competitiveness
But if profits are low, there could be
difficulties
What is the current situation?

36. Overall, corporate profitability
is exceptionally high
10.3
11.1
11.9
14.5
15.6
6
8
10
12
14
16
18
2002-03 2003-04 2004-05 2005-06 H1 2006-07 H1
Gross profits to sales, RBI Bulletin

37. More recent data
Analysis of October-December 2006
quarterly results of 808 companies
(Business Standard) showed a:
67 per cent increase in net profits, and
35 per cent increase in net sales.
January-March results are still coming in,
but they show a similar story

38. Exporters have been gaining
global market share
IVIIIVIIIVIIIVIIIVIIIVII
200620052004200320022001
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Share of Global Exports of Goods
indbp02g
(In percent)

39. …but the appreciation could hurt
some labor-intensive sectors

40. To summarize
Weighing the advantages and
disadvantages is difficult
RBI’s (and public’s) priority now is
controlling inflation
But the REER appreciation is significant,
and could hurt some key sectors
What are the RBI’s options?

41. Roadmap of Presentation
Why is the exchange rate appreciating?
The trillion-dollar question: is the rising
rupee a good thing – or a problem?
What are the RBI’s options?

42. Sterilization: the first line of
defence
Go back to the earlier problem: intervention
to defend the exchange rate fueled an
unwanted increase in the money supply
Is there any way to prevent this money
supply increase?
Yes! It’s called “sterilization”
RBI can buy up the excess rupees by issuing
bonds (MSS)
Or it can force banks to deposit these rupees at
the central bank, so they can’t lend them out
(CRR)

43. In fact, the RBI has issued MSS
bonds…
Outstanding MSS (Rs billion, 2006-07)
0
100
200
300
400
500
600
700
800
September
October
November
December
January
February
March
April
Data for April upto 20 only

44. …and it has increased the CRR
Reserve Requirements
4.0
4.5
5.0
5.5
6.0
6.5
7.0
23rd Dec 6th Jan. 17th Feb. 3rd Mar. 14th April 28th April

45. … moderating the increase in
reserve money
Reserve money growth (percent)
14%
16%
18%
20%
22%
24%
26%
28%
Nov-06 Dec-06 Jan-07 Feb-07 Mar-07
Actual
Implied

46. So, does sterilization solve the
problem?
Not really!
Sterilization creates problems of its own

47. Problems with CRR increases
A tax on the banking system, as banks are
forced to place funds in non-interest bearing
accounts, rather than loan them out
Imposes a large and disruptive shock to the
system: all banks are forced to come up with
funds to deposit at the RBI
Not a problem for those which brought in foreign
exchange and now have excess rupees.
But what about the others?

48. Problems with MSS
MSS is less disruptive and more market-
friendly, since bonds will be bought (only) by
banks with excess funds
But then the government has to pay interest
on the bonds, potentially forever
The interest costs mount with each dollar of
intervention
This spending could be put to other uses,
such as building roads, hospitals, and schools

49. Cost of sterilization
The annual “carrying cost” of the
December-February intervention is
about Rs 25 billion
If intervention continued at this rate for
another three months, the annual cost
would be Rs 50 billion
If it continued for a year, the annual
cost would be Rs 100 billion!

50. How does China do it?
After all, China has intervened much
more than India
They have kept their exchange rate
very stable against the dollar, amassing
huge amounts of reserves, while
keeping reserve money growth below
India’s level!

51. Foreign exchange reserves crossed a
trillion dollars in 2006
China: Official reserves and Reserve money growth
.
0
200
400
600
800
1000
1200
2001 2002 2003 2004 2005 2006
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
Foreign exchange reserves (US $ billion) Reserve money growth

52. Do they have a special
technique of sterilization?
Not really. They also sell bonds and
increase the CRR
Key difference: Chinese interest rates
are much lower.

53. China actually earns more on its reserves
than it pays on its sterilization bonds
Interest differential on Chinese and US securities
China (3 mth central
bank bill rate)
US (10 year treasury
note yield)
0
1
2
3
4
5
6
7
Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07

54. But there are hidden costs
Chinese interest rates are low partly because
they control the banking sector
They force banks to accept low interest rates
and make loans to public enterprises
Then they recapitalize the banks when they
make losses. Recapitalization has cost billions
of dollars.

55. Also, intervention and
sterilization create market risks
Interest rate risk
IMF calculations in 2004 showed that a 100 bps increase in
U.S./Euro bond yields would reduce the capital value of
China’s foreign bond holdings by 10 percent, implying a
capital loss of 2 percent of GDP
Now, reserves are roughly twice as large
Currency risk
Also, each additional $100 billion in reserves would imply
losses of 2/3 percent of GDP if the exchange rate
appreciated by 10 percent

56. Implications
A sterilization policy would be costly and risky
for India
So, it may not be sustainable
If not, it could be disruptive when the policy
is abandoned
In that case, it might be better not to embark
on a policy of “guaranteeing” the exchange
rate in the first place
Firms could still hedge their exchange rate risk in
the forward market

57. This reasoning led the RBI to
stop defending the exchange
rate in mid-March
Daily exchange rate (Rs/$)
40
41
42
43
44
45
46
47
48
2-Jun-03
14-Jul-03
25-Aug-03
6-Oct-03
17-Nov-03
29-Dec-03
9-Feb-04
22-Mar-04
3-May-04
14-Jun-04
26-Jul-04
6-Sep-04
18-Oct-04
29-Nov-04
10-Jan-05
21-Feb-05
4-Apr-05
16-May-05
27-Jun-05
8-Aug-05
19-Sep-05
31-Oct-05
12-Dec-05
23-Jan-06
6-Mar-06
17-Apr-06
29-May-06
10-Jul-06
21-Aug-06
2-Oct-06
13-Nov-06
25-Dec-06
5-Feb-07
19-Mar-07
30-Apr-07

58. Any other options?

59. The second line of defense:
capital account regulations
Some small steps have already been take to discourage
inflows:
Reinterpretation of pre-IPO capital inflows in real estate sector, to
disqualify them as FII investment
But major changes would be difficult
Now that India is so highly integrated with the rest of the world,
major capital account restrictions would be highly disruptive
It would also send a damaging signal to the business community
that even fundamental reforms can be reversed
Earlier this year, Thailand imposed some partial capital controls
The stock market fell 15 percent on the first day, forcing the
authorities to repeal many of the measures

60. Capital account regulations/2
A more promising alternative would be to
liberalize some of the remaining controls on
outflows
The RBI has been doing this, raising overseas
investment 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 $4
bn (April)

61. Conclusion
India is now living in a Brave New World, a globalized one,
where the old policy approaches may no longer apply
In particular, one of the problems of success is that India is
attracting large capital inflows
Dealing with these inflows is difficult; no country has found the
magic solution
Intervening to defend the exchange rate can help preserve
export competitiveness, but it can endanger the inflation target
Sterilization can “square the circle”, but is costly and ultimately
not sustainable
Liberalizing capital inflows is one possibility, but it is not a
complete solution
So, the Reserve Bank has some difficult choices to make

62. What would you do?

64. Also, competitiveness is not just
a matter of the exchange rate
The REER has been rising since 2002
But exports of goods and services have
roughly tripled
And profits soared

65. How did this happen?
Many explanations
Customs duties were reduced
Capital controls were relaxed
Transport and communications
infrastructure improved
In short, India developed, and as this
occurs REERs naturally tend to rise

67. Exporting is not an end
It is a means to achieving competitive
firms
It is this process that generates growth