Why A Rupee Depreciation Is Better Than Selective Customs Tariff Hikes

Given the relative strength of the rupee, despite recent blips, India’s growth story would be better served by a quick, managed depreciation of the currency than by letting it drift and find its own level.

Depreciating the rupee would be a far superior option to raising tariffs selectively, as the last budget did, unless the selectiveness is part of a broader strategy of building domestic manufacturing strength in some sectors with the medium term aim of achieving scale and ultimately global competitiveness. Indefinite protection will not serve our national goals.

In the Union budget, Finance Minister Arun Jaitley announced an increase in customs tariffs on many items, claiming this will help domestic value addition. He said: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty. There is substantial potential for domestic value addition in certain sectors, like food processing, electronics, auto components, footwear and furniture. To further incentivise the domestic value addition and Make in India in some such sectors, I propose to increase customs duty on certain items. I propose to increase customs duty on mobile phones from 15 per cent to 20 per cent, on some of their parts and accessories to 15 per cent and on certain parts of TVs to 15 per cent. This measure will promote creation of more jobs in the country.”

These tariff increases are now law following the passing of the budget by the Lok Sabha yesterday (14 March).

Most economists read this as a return to the old days of import substitution and protectionism, both of which led to poor product quality and slower growth. Efforts by the Donald Trump administration in US to raise tariffs on steel and metals are raising similar concerns. The Cassandras would be right if Jaitley’s duty increase is anything more than a temporary measure. If it lingers beyond two years, it will be counter-productive. Not only will it not boost Make in India, it could slow down growth and impact exports negatively.

A quick exit from tariff increases is possible if the government were to devalue the rupee – either in one quick policy swoop, or through a deliberate policy of steady depreciation facilitated by loose talk about the rupee being overvalued. If government officials start muttering darkly about limiting foreign investment in government debt, or dent foreign inflows by proposals to tax capital gains (already done through the imposition of the 10 per cent long-term capital gains tax), outflows will automatically beat the rupee down. A constriction in the supply of dollars, which is already happening due to prospects of the US Federal Reserve raising interest rates quicker than expected earlier, will additionally depreciate the rupee.

If the rupee is depreciated by, say, 5-10 per cent, it will have almost the same revenue and protectionist effect as the budgeted increase in import tariffs. Only, the world won’t call it protectionist. It will make imports costlier, and exports more lucrative. India’s growth cannot decisively hit eight per cent or more without the export engine firing. A rupee depreciation is thus warranted, and a superior way of giving domestic production a leg up that selective tariff increases.

As things stand, the rupee has oscillated between 65.7 to the US dollar and 63.3 over the last 12 months, and this level is simply too high to give exports a decent fillip.

The Reserve Bank of India’s real effective exchange rate (REER) shows that the rupee is overvalued by 22-30 per cent (see the details here), depending on whether the REER is trade-weighted, export-weighted or currency trade-weighted. REER is the weighted average value of a currency against a basket of other currencies after adjusting for inflation. The high REERs for India suggest that the currency is clearly overvalued, and some depreciation is called for.

There is, however, a downside. When imports become costlier, it can impact domestic inflation, especially through higher prices of oil. One way to neutralise the price impact on oil imports is to open a separate dollar window for refining companies, who can be offered greenbacks at a discount. This will cushion the impact of imported inflation in the short run, but in the long run would also distort the market and incentivise the use of imported oil. On the plus side, India is also a huge exporter of refined petroleum products, and a rupee depreciation would boost exports of these items.

India’s choices at this point are difficult: we have the option of keeping inflation moderate and growth sub-optimal, or raising growth while raising the risks of inflation. The inflation beast can be handled partly by the above method, and partly by ensuring that price increases in items of common consumption are kept moderate.

There is, of course, no guarantee that a depreciation of the rupee will push up exports, but there would be one additional advantage worth considering: when you get more rupees per dollar, you essentially incentivise export over-invoicing and inward remittances of illegal (and legal) hoards of dollars held by individuals and companies. This will not only reduce the amount of illegal wealth held abroad, but also aid the domestic recovery process by making rupee resources available to promoters and their overleveraged companies. It makes economic sense to tilt the growth levers in favour of export inflows by depreciating the rupee.

When a country is fighting black money, we also need to fight it smartly. At one level, the push towards formalisation and less tax avoidance results in higher costs for companies, and slower growth in the short run. On the other hand, if one winks at the money flowing in to help beleaguered companies and individuals, even if the colour of the money is suspect, it would counter this slowdown.

Rupee depreciation is a double-edged sword. Right now, the upsides look more enticing than the downsides look worrisome. It may be worth taking the risk and let the rupee drift down faster.

(A part of this article was first published in DB Post)