Rupee appreciation upsets export arithmetic

Imagine a Tirupur garments exporter competing with a Chinese company for American market share. This is a classic example of an Indian exporter running economic exposure on his business. The exporter has a basic transaction exposure against the US dollar. But he also runs an equally or even more significant economic exposure against the Chinese yuan. If the yuan does not appreciate or rises less than the rupee’s gains against the dollar, the Indian exporter faces a serious threat to his share in the US market as there is an effective Chinese price cut in such a scenario. Any attempt to match the effective lower Chinese prices actually compounds the problem for the Indian exporter as his final rupee realisations are under greater pressure then.

The Chinese example has been cited here to just highlight the issue of economic exposure which Indian exporters face in today’s extremely competitive global trading environment. Indian exporters are obviously facing competition from a number of other countries also in all their main export markets. It is not surprising, therefore, to see that while exports grow double-digit in dollar terms, the growth in rupee terms is severely constrained by the complex and inter-connected risks in global merchandise trade. For the first five months in FY-08, for instance, while growth in dollar terms is 18 per cent, that in rupee terms is just 5 per cent.

At one level, these developments possibly just show the limits of export-led growth and activity in a country such as India. Indeed, with exports constituting only around 12-13 per cent of GDP, one may wonder how critical is the export-led model for India. The domestic market is huge and the level of consumption/investment demand is high enough for the country to run, even if only modest now, trade deficits.

It is quite different in the case of China where exports are a national industry (as a matter of deliberate policy) and account for more than a third of total national income and domestic consumption (though now opening up) is still largely suppressed. This structural difference between India and China is also reflected in the fact that while Chinese FX reserves are basically export surpluses, Indian FX reserves are basically capital account surpluses. At another (micro) level, the export statistics also show that in a complex and competitive global trade environment, Indian exporters are possibly not yet tuned into the need for proactive (and sometimes pre-emptive) financial risk management.

Hedging economic exposure may possibly call for more advanced financial instruments (such as currency options on the currencies of competing countries for instance) and their active use. But it is one of the quirks of the global trade/markets system that while a country such as China seeks to enjoy all the benefits of open, free consuming markets of the world (specifically the US), it picks and chooses which part of the global trade/market rules it will comply with. For instance, it heavily manages its yuan currency and also, as a corollary, does not allow internationalisation of the currency. (Most other Asian currencies except Japan also fall in this bracket. Japan has traditionally intervened heavily in its currency but the yen is one of the key international currencies also. Also to be noted is that Japan has not intervened in the yen since March 2004.)

Therefore, hedging economic exposures actively is still some way off. Indian exporters, though, can well and truly hedge transaction exposures with the available instruments in the local markets. The underlying math relating to the export sector — on export costing and pricing for instance — only seems to make that imperative.
The underlying math on exports

An analysis of the math (see Table) is necessary to throw light on the underlying economics of the export trade at the individual exporter level. If not anything else, it may at least point to how important active hedging is for Indian exporters in the current and emerging environment.

Consider an Indian company which exports only to the US market. (This is quite a realistic scenario in Tirupur, for instance, where there are a number of mid-size exporters who sell almost entirely in dollars/ to the US market).
The Economics

Equation 5 also brings out clearly how rising costs and an appreciating local currency can apply pressure on both the cost and revenue sides and render the export trade quite uneconomic.

For example, assuming per unit cost of production is Rs 100, an exchange rate of Rs 45 to the dollar and a price elasticity of 2, one can see that the unit dollar price for the exporter will be 100/45 (1-0.5) = 4.5.

Now, if production costs rise and the local currency also appreciates (as has happened in the case of Indian exports), without any change in the price elasticity (elasticities are quite sticky in the short/medium term and also unlikely to change in the case of low value added items), the exporter will be literally priced out by his competitors who have not experienced such cost side pressures/local currency appreciation. Assuming that unit costs rise to Rs 120 and the rupee appreciates to 40 against the dollar, one can see that the equilibrium dollar price for the exporter should rise to at least $6 per unit. How many mid-size Indian exporters have the pricing power to increase negotiated and agreed upon prices?

Compare the above workings with that for a Chinese exporter who has not experienced such cost side pressures and also, importantly, benefits from a relatively much more stable currency. The Chinese yuan, for instance, has been allowed to rise around 9 per cent against the dollar in the two years since July 2005 — from 8.28 to 7.51 now — but the Indian currency is up 10 per cent in just the last 7 months.

It is obvious that the Chinese exporter will have a significant price advantage which can be extremely useful in increasing market share — particularly in low value-added items.

Equation 5 tells in a very concise manner how critical it is for the exporter to protect the (initial) exchange rate based on which his export pricing has been worked out. Such protection is achieved only through active and systematic hedging.