Mar 18, 2012

Should exchange-rate be a consideration in long term Foreign Trade Policy making?

We know that the Dollar/Rupee exchange rate plays an important role in trade dynamics of India. The question is, can the foreign trade policy of India take this into account while the policy is in making. If yes, what are the things that can be taken up at a trade policy level. And why? 

To give a brief background, exchange rate in India is currently a concern of central bank (RBI), and trade policy formulation is commerce ministry's work. Of course, there are interactions at certain levels between ministry of finance, commerce and RBI. Going by the statements that make it to the press from commerce ministry, it seems exchange rate is something about which commerce ministry is helpless and the most it can do, in cases when exchange rate starts hurting, is to request for additional sops for exporters. It happened whenever rupee appreciated during the past few years(e.g. see this, somewhat old, but typical response). It's more of an ad-hoc lobby work which pressurizes the Govt to dole out.

The overall thinking of the Government currently seems to be that exchange risk is something that the industry must factor in while doing business. To expect the Govt. to bail out every time exchange rate fluctuates is not reasonable. Hedging, maintaining foreign currency accounts and other such measures to offset currency risks should be taken by exporters/importers.

Now, the bigger question is, can the Foreign Trade policy be linked to the exchange rate in such a way that there are incentives built-in to offset the exchange rate risk? Currently, an exporter gets various incentives for exporting, none of which are directly linked to exchange risk. And if yes, should there be a difference in short term and long term approach towards this?

The further question that follows from this is, in the long run, does it help to have such incentives in place at all? The exchange rate, after all, is a reflection of the fundamental strength of the economy, which in turn, is reflected by exchange of goods, that set the rate in the long run. Of course, in the short run, there might be a mismatch between the fundamentals and going rate due to capital flows, speculations, expectations, holding decisions and so on. However, in the long run, the competitiveness and the relative advantages enjoyed by an economy determines the trade pattern and volume.

So what would happen if the industries are left to adjust to the emerging exchange rate autonomously?
If we do that, we might find that in case of currency appreciation, some industries might come under trouble.  Some might not be sustainable. Such sectors might protest, form lobbies and meet ministers with requests to help them. How should the minister go about it? Should he adopt a policy to oil the wheel that squeaks and give doles based on the noise?

I feel that the best way to approach it is to have an analysis regarding sensitivity of individual industrial sectors to determine the effect of strong rupee. Based on this, one can design a system to take care of adverse affect of currency movement by giving incentives to that sector to improve competitiveness and productivity, so that they survive in the long run.

And in the short run, give some doles to the lobbies. Because, if the baby is crying, it must be hungry. And, to survive in the long run, you must first survive the short one.