Do you think that the Currency Exchange Rate is a suitable measure for comparing countries’ relative economic performance? What are the possible reasons for widening trade deficit in India despite improvement in macro-economic fundamentals? (200 W)

Mentor’s Comment:

The question has two parts. In first part we need to establish the relationship between exchange rate and economic performance of countries and take a stand whether it is a suitable measure or not. Though, there is no direct linkage between them, but over a short term exchange rate can mislead economic situation. Strong exchange rate for long term can depress economic growth as it makes exports more expensive and imports cheaper thus reducing the demand for domestically produced goods.

In the 2nd part we need to highlight the improving macro-economic condition and then describe the current trade deficit situation in India. India is registering average GDP growth of 7.5% between 2014-15 and 2016-17 being among the best performing state in the world. However, despite growth, the trend shows increasing current account deficit which is primarily due to higher trade deficit.

There are various factors responsible for such trend. Like Subdued external demand, Impact of GST, Increase in commodity prices, Electronic as new oil, No commensurate increase in export value and higher interest rate & bond yields.

Further, conclude by saying that India need to ensure robust credit growth, establish proper infrastructure to facilitate efficient supply chain linkages, capture new export markets and increase investor’s confidence to boost its domestic growth.

Model Answer:

The exchange rate is determined independently of the growth rate of the economy. With many variables involved, there is no direct link between the two. However, both can influence each other. Over a short term, a strong exchange rate can be misleading to the overall economic situation because it might be driven by speculation rather than long-term economic improvement. In fact, strong exchange rate can depress economic growth, as it makes exports more expensive and imports cheaper thus, reducing the demand for domestically produced goods.  Further, exchange rate does not reflect the economic performance due to domestic consumption of domestically produced goods.

Still, a stronger exchange rate over a long period of  time can be considered as  a suitable measure for relative  economic  performance  of  countries  as  it  generally  reflects  low  inflation  level,  high competitiveness, greater global demand for products etc.

As such, it is the stability or volatility in exchange rate that closely determines economic performance rather than merely the value of the rate. A stable currency evokes confidence in an economy whereas a volatile currency signifies threats and vulnerability to speculations.

However,  India  even  after  displaying  improvements  in  macroeconomic  indicators  such  as  registering average GDP growth of 7.5% between 2014- 15 & 2016-17, being among the best performing economies in the world, moderate inflation rates etc., shows increasing trend in Current Account Deficit   primarily due to higher trade deficit. In 2017-18, India’s trade deficit increased to US$ 160 billion from US$ 112.4 billion in 2016-17. Various factors are responsible for this situation:

  • Subdued external  demand:  Global  economy  is  still  recovering  and  it  is  expected  to  pick  up  the momentum  over  the  current    However, current global regime moving towards protectionism and trade wars does not augur well for global trade.
  • Impact of GST – Operational issues in GST such as delays in input tax credit and Integrated Goods and Services Tax (IGST) refunds for exporters is leading to blockage of working capital. Also, unorganized segment has also not been prepared for high compliance burden.
  • Increase in commodity prices: Oil imports are now almost over 50% higher by value as compared to last year. Rise in major import items such as oil, gold etc. ends up increasing the trade deficit.
  • Electronics as ‘new oil’: Net electronics imports continue to rise unabated accounting for 25 per cent widening of deficit. Unless, government quickly ramps up the electronic production, given its size, it may emerge as the ‘new oil’ for India.
  • No commensurate increase in export value: Exports have failed to match the increase in imports, which are increasing riding back on surge in gems and jewelry imports. Further, India is also losing its competitive edge in core categories like textiles and agricultural exports to other countries.
  • Higher interest rates and bond yields: This has increased the cost of corporate borrowing making it difficult to service corporate debt and putting highly leveraged corporate balance sheets further at risk.

India  needs  to  take  the  benefit  of  the  synchronized  global  recovery  through  trade  facilitation  and competitive  products.  Moving  forward,  it  also  needs  to  ensure  robust  credit  growth,  establish  proper infrastructure  to  facilitate  efficient  supply  chain  linkages,  capture  new  export  markets  and  increase investors’ confidence to boost its domestic growth.