Also read: Should RBI prevent further rupee appreciation?
Gokarn along with Samiran Chakraborty, head - Regional Research (South Asia) at Standard Chartered Bank shared his views on the RBI's role in stabilising the Indian currency.
"The rupee rising is bringing down the cost of unavoidable imports. It is therefore feeding through into lower inflationary pressures domestically. So, to prevent the currency from rising in an inflationary situation means that you are going to have to do something more on the interest rate side to offset the inflationary pressures of an undervalued currency. That is the choice that has to be made," adds Gokarn.
Below is the edited transcript of the discussion on CNBC-TV18.
Q: The connection is very compelling, as the currency has depreciated between 10-15 percent year-to-date and from year ago levels we have seen a salutary impact on the trade deficit. So at least to keep the trade deficit under control should the RBI concentrate on not allowing the currency to appreciate?
Gokarn: One cannot look at the currency and the management of the exchange rate as an isolated and standalone objective. You have to look at currency dynamics in the larger context of what is happening in the economy. And the very simple link is that if you are managing an inflationary situation, if the objective of monetary policy is to rein in inflation which clearly in the current circumstances it is, then the appreciating currency actually helps you do that.
The rupee rising is bringing down the cost of unavoidable imports. It is therefore feeding through into lower inflationary pressures domestically. So, to prevent the currency from rising in an inflationary situation means that you are going to have to do something more on the interest rate side to offset the inflationary pressures of an undervalued currency. That is the choice that has to be made, I am not arguing that one is necessarily superior to the other but you have to be aware of the tradeoff that is involved.
If one wants to protect the export sector, and keep the CAD under control by resisting the rupee appreciation, then squeeze on domestic demand is needed to manage inflation. Hence, what one is achieving is an expenditure switch or a demand switch.
You are pushing demand towards the export sector by keeping the currency undervalued. But you are offsetting that by reducing domestic demand which means you may be squeezing investment or domestic consumption.
That is a choice that policy makers have to exercise. But I don't think we should be operating under the notion that somehow you can do currency management and it is not going to have any consequences on the rest of the economy.
Q: Are you in agreement with the theory that the depreciation of the currency has helped in bridging trade deficit?
Gokarn: Yes overtime, we should be looking to see an improvement in the export performance as a result of the currency having depreciated. One thing that has also contributed to an improvement in the trade deficit from my view is that the US marketrs have actually now started to recovery.
Take away the last two weeks, the shutdown and the debt ceiling and all of that. Look at the US economy before that and after that. I think there is some buoyancy coming back into exports from the demand side. So, these factors are complimenting and to some extent offsetting each other.
When we talk about currency management, trying to peg the currency at a particular level, one has to take in account all the consequences that such an action has. And in the past when we have done it, we have experienced a massive increase in domestic liquidity.
It has been very difficult to sterilise all the results that were accumulated and so on. So there are consequences, there are side effects which will have to be accounted for and have to be thought about.
Q: Given this connection that in the past one year the rupee has depreciated by 15 percent and consequently the trade deficit has come down from USD 10 billion a month to about USD 7-8 billion a month. Is it very clear that a depreciating rupee is solving our trade deficit and CAD problems?
Chakraborty: There are sectors on which this is clearly showing up like on exports side. The growth that we are seeing on textile exports have been very significant this year. In the first five months, it is almost a 13 percent growth in textile exports, a significant improvement over the last year.
On imports side, on machinery imports, we are seeing a significant reduction in machinery imports which could be due to import substitution.
And lastly, there is a very curious case of petroleum exports where the currency depreciation has made the imports costlier but the government has not passed that in retail prices. So, it makes exporting that much more lucrative now and that is why probably we have seen more than a USD 3 billion increase in petroleum exports in the last five months.
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