India was one of a number of countries that experienced major currency devaluation against the dollar during and after the international currency crisis. As the comparison to China, which pursued a policy of stabilising the RMB's exchange rate against the dollar after the outbreak of the financial crisis, is particularly interesting the movements of the RMB and the Indian Rupee against the dollar since 2000 are shown in Figure 1.
Figure 1
As may be seen the Rupee from 2000 up to September 2007 had a tendency to a weaker exchange rate than the RMB. But the difference was not extreme and in September 2007 the two currencies were essentially at parity in terms of exchange rate shifts with a roughly ten percent upward movement in exchange rate against the dollar compared to 2000.
After September 2007, however, a marked divergence between the exchange rate of the RMB and the Rupee began. The RMB first continued to rise and then stabilised, without falling, when the financial crisis began. The exchange rate of the Rupee, in contrast, start falling from September 2007 onwards and this accelerated as the financial crisis developed. The specific trends since the start of the financial crisis are shown in Figure 2.
Figure 2
Taking these movements together, between September 2007 and January 2010 the RMB rose by over 10% against the dollar while the Rupee fell by over 20% between September 2007 and its low point in March 2009. Even after recovery of the Rupee, at the beginning of January 2010 it was still more than 12% below its September 2007 level. As the RMB went up against the dollar in the same period this means that the Rupee has carried out an effective twenty per cent devaluation against the RMB since September 2007.
Given that India runs, relative to the size of its economy, a containable balance of payments deficit, which in 2008 was 2.7% of GDP, no substantive internationally destabilising consequences flow from the devaluation of the Rupee against either the dollar or the RMB. What will be significant however will be to see whether this clear devaluation of the Rupee against the RMB alters the relative dynamics of India's and China's economies.
As this blog has noted on a number of occasions the long term effect of India's economic reforms has been to shift it decisively towards the 'Asian growth model' - that is to a very strong increase in savings and investment rates. Indian Prime Minister Manmohan Singh has consciously supported this policy.
The decline of the exchange rate of the Rupee moves India further towards adoption of the 'Asian growth model'. This is because for countries such as South Korea and China a second component of their economic strategy, alongside high rates of savings and investment, was to maintain a low exchange rate in order to boost exports.
Contrary to accusations to the contrary this did not necessarily mean running a large trade surplus, as this depended on developments such as the rate of growth of the economy which helped determine whether imports rose equally - for example China's large trade surplus appeared only in 2005 and is now declining, while South Korea at various times has run large trade deficits. The low exchange rate policy, however, did ensure a rapid development of the share of exports in the economy, allowing economies of scale from production for the international market and other benefits to be achieved. The fact that India was more cut off from the international division of labour compared to is east Asian competitors, that is its share of exports and imports in the economy was relatively low, was an achilles heel.
Having achieved a level of savings and investment which is currently higher than South Korea and the other former East Asian tigers, and is not far behind China, the logical next step for India is to adopt a low exchange rate policy to stimulate exports still further. The changes in the Rupees exchange rate in the last period give the opportunity to achieve this. It remains to be seen whether they will be consolidated.
In addition to the importance for India itself there is an international significance of India's further shift towards a policy of a high savings and high investment coupled with a low exchange rate to stimulate exports. For this, as noted, is precisely the 'Asian growth model'. The fact that the world's second most populous country, soon to become its first, is moving with success further towards such a model has clear implications. Far from the 'Asian growth model' moving to its end after the financial crisis, as some commentators have claimed, it is spreading further.
Watching the exchange rate of the Rupee, and its effect on India's economic performance, is becoming a highly important international issue.
The arguments raised by Micheal Pettis in the link above- namely that Chinese growth will be constrained by a lack of aggregate demand in the the context of decreased export opportunities and insufficient internal consumption is reliant on a misunderstanding of the relationship between consumption and aggregate demand- effectively reducing the latter to the former.
Aggregate demand can be seen as composed of three components- domestic consumption, domestic investment, and net exports. Pettis essentially argues that a decrease in net exports will inevitably lead to a shortfall in aggregate demand unless domestic consumption rises accordingly. The option which he overlooks, and is closer to that which China has actually pursued, is to raise domestic investment.
The argument often levied against such an approach is that increased investment means an increased expansion in productive capacity, which will only accentuate any pre-existing shortage of aggregate demand in relation to capacity.
However, it is possible, even within a completely closed economy, for aggregate demand to rise in line with productive capacity at any level of investment. All that is required is that domestic purchasing power expands at the same rate as the capacity for producing consumption goods, and that savings rise in line with the productive capacity of the investment goods sector.
For steady state growth with high capacity utilisation, all that is required is that the absolute value of investment and consumption expand at the same rate as overall output expands. Thus the % share of both components will remain constant. A higher rate of investment will in such a situation create a higher rate of capacity expansion, and consequently necessitate a greater growth rate in consumption and investment expenditures.
The above principles can be demonstrated through a very simple example. Consider a closed economy running at full capacity with a GDP of 1 trillion, with investment at 40% of GDP and consumption at 60%, and an ICCR (Incremental Capacity to Capital Ratio) of 4. After one year capacity will have increased by 10% (40% / 4). To maintain full capacity and the preexisting shares of consumption and investment, domestic consumption must rise from 600 billion to 660 billion, whilst domestic investment must rise from 400 billion to 440 billion.
What is important in terms of aggregate demand is not the absolute or relative value of domestic consumption but the rate of increase- so long as the rate of expansion of consumption is roughly equal to the rate of overall economic expansion steady state growth is possible at any level of consumption as a percentage of GDP.
This can be confirmed by applying different values to the above example- for example, steady state growth would also be possible with a rate of investment at 60% and consumption at 40% of GDP respectively- however in such a case the rate of capacity expansion would rise to 15 %, and consumption would need to rise from 400 billion to 460 billion, whilst investment would have to rise from 600 billion to 690 billion.
Real economies may deviate substantially from a steady state growth path, thus crisis relating to disproportions between the demand and capacity within particular sectors can and do occur. Dealing with these disporortionalities may actually require a large degree of economic planning. But so long as these issues are resolved, there is no theoretical reason why aggregate demand cannot match aggregate output even with consumption existing as a relatively small proportion of GDP- in fact full capacity steady state growth is possible so long as consumption increases at the same rate as GDP expansion.
This appears to be exactly what is occurring within China- whilst wages may indeed be low- both in relation to remuneration elsewhere and the productivity of those workers, the rate of increase in remuneration, especially of urban workers, appears to match or even exceed the rate of GDP expansion. (See for example Dic Lo, ‘China’s Quest for Alternative to Neo-liberalism: Market Reform, Economic Growth, and Labor’, The Kyoto Economic Review, 76 (2007), 193-210)
Posted by: Kieran Latty | January 07, 2010 at 01:22 AM