Appreciation of the rupee: a divisive issue

 Angel Merkel, the German Chancellor rejected French calls for a summit of the eurozone leaders to exchange views about monetary policy , feeling that it to be potentially divisive. Eurozone monetary policy and the resulting strengthening of the Euro is a bone of contention between Paris and Berlin.
The Chancellor warned against any attempt to dilute the independence of the European Central Bank and asserted that the recent appreciation of the euro against the dollar was an expression of the EU’s economic strength. Even the boss at the European Central Bank, Jean -Claude Trichet, groused about the brutal movements in the dollar-euro exchange rates that was slashing profits of Europe’s biggest firms. Airbus CEO had warned that a weak dollar was threatening the long term existence of the continental aerospace giant. It would be plainly stupid to advice the CEO to opt for hedging in a situation where the falling dollar is eating in its profits and the trend is clearly uni-directional.

Here also, the appreciation of the rupee is gradually becoming a divisive issue. Captains of industry have been complaining about the appreciation of the rupee after the substantial deprecation in 2006 while the authorities have been arguing that present value of the exchange rate is more or less in line with the economic fundamentals.

Ali Parkar, President of the Star Knitwear group is sounding the alarm :  «Nous sommes dans une situation de crise. L’industrie textile est sous forte pression à cause de l’appréciation de la roupie. Le gouvernement doit accepter sa responsabilité car, s’il refuse de gérer la roupie, ça risque d’être fatal à toute cette industrie d’exportation. Je ne suis pas d’accord avec le ministre des Finances qui soutient que la valeur de la roupie reflète les fondamentaux de l’économie. Les importations dépassent largement les exportations. Pour la différence l’économie dépend des services, du tourisme et d’autres transferts d’argent. C’est la situation qui a prévalu pendant longtemps et la valeur de la roupie a été toujours raisonnablement gérée. »

The strong rupee faction points to the improving macroeconomic situation : the Overall Balance of Payments is showing a surplus of around 7 billion and foreign reserves of Rs 88.0 billion as at end November 2007 equivalent to 41 weeks of imports and Gross Foreign Direct Investment inflows that have already reached Rs 9 billion as at September of this year; the economic recovery is turning out to be more robust than excepted with a  5-6% growth trajectory on the strength of EPZ ,tourism and construction of integrated resort schemes and boosted by the rupee depreciation. The proponents for a weaker rupee, however, advice that we look more closely at this performance. Short term and particular factors predominate, and the grounds for lasting growth are pretty weak.  EPZ exports have benefited from the re-imposition of quotas on Chinese exports and rupee depreciation; tourism is riding on favourable global trends, IRS schemes are leading to much construction activity, and bringing in foreign direct investments (FDIs). As at September, it represented 70% of FDI inflows exclusive of flows to the banking sector. Moreover they point to some prevailing imbalances in the economy namely the  high current account deficit of around 10 % of GDP and an inflation rate of around 9 % that leaves the Central Bank with the difficult  policy choice of trying to shake off  inflationary pressures and entrenched inflation expectations without stealing momentum from the recovery.

The reasons for the  intervention of the Central Bank (CB) in the foreign exchange market also divide the two groups; the stronger rupee camp expects the CB’s intervention to be limited to the smoothening of the volatilities  while the other side, though accepting that the CB is primarily concerned with inflation, is convinced that it should also intervene in the foreign exchange market with a view to preserve the country’s external competitiveness while minimizing volatility. This essential function of the CB is clearly specified in the Bank of Mauritius Act 2004. “The Bank shall have such functions as are necessary to achieve the attainment of its objects and, in particular, it shall conduct monetary policy and manage the exchange rate of the rupee, taking into account the orderly and balanced economic development of Mauritius”.

The beginning of the unwinding of the US imbalances and the weakening of the dollar seem to provide them with some essential fodder. Drawing on what appeared to be a similar situation, they highlight the fact that the substantial excess of savings over investment –the global savings glut-predominantly in China, Japan and the oil exporters, led to the relatively low level of long-term global real interest rates and increased foreign demand for U.S assets. The short term effect has been an appreciation of the real exchange rate while the current account deficit in the U.S reached some 6.5 percent of GDP in 2006.  The huge inflows masked in certain ways the imbalances in the US economy. These trends cannot persist over the long term and the adjustment had to come via a weak dollar. The easy supply of global credit had hooked the US government and US homeowners on easy credit and when that capital gets invested elsewhere, the withdrawal will be painful. Foreign investors would demand a big interest premium on US assets to compensate for the capital losses. It could also make it more difficult (or expensive) for the US government to finance its massive budget deficit. Traders would dump dollars accentuating the fall of the dollar’s exchange rate.  The similarity with the Mauritian situation is the FDI inflows to the IRS projects; it is temporary and it does not in any way boost our export potential. There is no transfer technology or know-how or any multiplier effects on the economy especially for these IRS projects that are not integrated to the tourism industry.

The weaker rupee camp describes this as a symptom of the "Dutch disease," a term that broadly refers to the harmful consequences of large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment. The term was coined in 1977 by “The Economist” to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s.  The increased supply of foreign currency would drive up the value of the domestic currency, which also implies an appreciation in the real exchange rate, -that is, a unit of foreign currency now buys fewer "real" goods and services in the domestic economy than it did before- in the case of flexible exchange rates through a rise in the nominal exchange rate rather than in domestic prices. Real exchange rate appreciation weakens the competitiveness of the country's exports and, hence, causes its export sectors to shrink. Thus if the FDI inflows prove to be temporary, the authorities should protect the export sectors—possibly through foreign exchange intervention.

The strong rupee side however has growing doubts that the policy of competitive depreciation that have served us so well since the 1980's can still be relied upon to provide the necessary cushion to our export sectors. The late Prof. R. Dabee's in the “Mauritian economy: A reader” had raised this concern some years back in 2001 that "the competitiveness of Mauritian exports should be reinforced by other policies which can increase the productivity of the export sector”.  (possibly through continuous restructuring and investing in worker retraining) . But meanwhile while we forge ahead to acquire the required agility, skills and flexibility in our enterprises to move to up the value chain, the pro-weaker rupee group argues that we have to strike the right balance between the need to maintain price stability and the need to safeguard the competitiveness of our export sectors.  The pursuit of a sound and consistent exchange rate policy is fundamental for a small open economy like Mauritius.  We cannot afford now to have policy inconsistencies. The reorientation of the exchange rate policy to tackle inflationary pressures, however well intentioned, cannot attract credibility if it is not conducted in full transparency and with the support of fiscal, wage and other economic policies that enhance our productivity and flexibility. (“Education and human capital formation- the key to higher productivity. Plus globalement, il faut mesurer la performance en termes d’amélioration de sa productivité, de votre système éducatif. Se comparer avec les meilleurs systèmes du monde. Voilà l’essentiel. ” Paul Romer recommends)

The Dutch disease argument has a broader relevance when we dare to examine more closely our development options. Mauritius had adopted a very distinctive development path. Mauritius chose such a development option that squeezed the population per sq km , (now some 611.24 persons per sq km and ranked 18th in the world in terms of population density) in order to release enough land that would be conducive for the exports of goods and services. Arvind Subramanian and Devesh Roy notes in “Who can explain the Mauritian Miracle: Meade, Romer, Sachs, or Rodrik?” that “Mauritius has also enjoyed preferential access on its exports of textiles and clothing. In return for guaranteeing the rights of the sugar owners, the political majority did implicitly extract a compromise in terms of transferring some of the rents from sugar to itself. One important aspect of this transfer was a large, relatively well paid, civil service (staffed predominantly by the majority Indian community) and a generous system of social protection, particularly related to pensions.  The success of the sugar industry in Mauritius can thus be seen as an example of what can be termed as optimal rent sharing between the political (predominantly Indian) and economic elites (predominantly non-Indian).” We tacitly agreed to live one on top of the other as long as we were providing enough of avenues for the growth of exports of goods and services. Does it make any sense now to keep on piling on top of one another while the sugar , ex-sugar owners and others speculate on that precious land and convert Mauritius into a real estate jungle peopled by outsiders without boosting our future export potential? The sharing of the optimal rent ( rent from land speculation) goes on with difference that it has now become somewhat more inclusive on the margin.

 However if that precious land is instead allocated to centres of excellence,-educational, medical, BPO, financial and other consultancy services and these generate substantial FDI inflows  it would be a different development option altogether.  The talented professionals that we intend to attract in the services sector, as suggested by Prof P. Mistry, would not be needing poshy bungalows but social and physical infrastructure of international standards.  We are not providing ourselves with the means to realise our vision of becoming a more diversified services and knowledge-based economy.