How to explain the IMF’s pessimism on the Indian rupee?

The International Monetary Fund (IMF) publishes its World Economic Outlook (WEO) twice a year after its spring and fall meetings. It also provides mini-updates in January and July, for selected countries where the facts on the ground may have changed significantly. The latest edition of the WEO was released last month.

For India, in April, the Fund had forecast a real gross domestic product (GDP) growth rate for 2021-22 of 12.5% ​​in Indian rupee (INR) terms. However, that forecast has now been lowered to 9.5%. Its forecast for 2022-23 was 6.9% earlier and has been raised to 8.5%. To some extent, the downward revision to 2021-22 is understandable. India suffered a second wave of covid infections in April and May this year. However, since then, many private sector economists have raised their forecasts for India’s economic growth this fiscal year to double digits, based on more recent and real-time indicators, including mobility data. . The Reserve Bank of India (RBI) maintained its forecast at 9.5%.

In the case of China, the Fund’s forecast for 2021 has also fallen. Compared to April, it is down from 0.4% to 8.0%. It is down 0.1% from the July estimate. For 2022, the GDP growth estimate is 0.1% lower at 5.6% compared to July. Compared to April, it is unchanged. As a result, in the July WEO update, the Fund had actually raised China’s growth estimate for 2022 by 0.1% from April. But what is more interesting are the Fund’s medium-term forecasts for the next five years. For India, it is until 2026-27 and for others following the calendar year, it is until 2026.

In October, India’s nominal GDP for 2026-27 was projected at 392.84 trillion and 4.393 trillion dollars. In the April WEO edition, the corresponding forecasts were $389.01 trillion and $4.534 trillion. So, high school arithmetic will tell us that the Fund became relatively more bearish on the Indian Rupee against the US Dollar (USD) in October than in April. From 70.9 in 2020-21, the Fund sees the Rupee depreciating to 89.4 against the US Dollar by 2026-27. In April, the implied exchange rate forecast for 2026-27 was 85.8. Thus, the US dollar is 4.2% stronger at the end of 2026-27 according to the October 2021 forecast compared to the April forecast. The effect is that India’s nominal GDP in US dollars in 2026-27 is $140 billion lower than the April forecast.

Let’s take a look at what the IMF did with its forecast for China. For 2026, in April, the Fund forecast a nominal GDP of 161.883 billion yuan and 24.128 billion dollars. By October, those forecasts had risen to 160.5 trillion yuan and $24.996 trillion. This is the opposite of revisions to India’s GDP forecast. In the case of India, nominal GDP in rupees increased by almost 4 trillion and GDP in dollars is $140 billion lower. In the case of China, nominal GDP in CNY terms is about $1.4 trillion lower and nearly $900 billion higher. In sum, China’s GDP is close to $25 trillion in 2026 and India’s is quite far from $5 trillion by 2026-27, according to Fund projections.

When it comes to forecasting exchange rates, the literature tells us that economic fundamentals do a poor job for any horizon less than three years. Afterwards, the fundamentals are asserting themselves and doing quite a good job. Of all the economic fundamentals that influence exchange rates, the only persistent factor is the inflation differential. In other words, relative purchasing power parity holds over long horizons. Almost a decade ago, in their yearbook of annual returns on Credit Suisse investments, financial historians Dilroy, Marsh and Staunton noted that the pound sterling had depreciated by around 1% on average per year between 1904 and 2004. The annual inflation differential between the UK and the US was also around 1%. Thus, assuming that inflation differentials will better explain the dollar-rupee exchange rate over a 5-year horizon is not an unrealistic assumption.

But a space of disagreement arises in the interpretation of the incremental data flow between April and October. Even the US Federal Reserve admits that the high inflation rate in America that was seen as transitory is now seen as more permanent. Consumer price inflation has been stubbornly at or above 5% for the past five months. There is talk of a “great resignation” movement in America. Many workers quit their jobs. There is a table of data on unfilled job openings in the United States available in one or two taps that is a sight to behold (bit.ly/3CPqRpE). The workers feel encouraged to announce a strike. These trends point to higher wages and therefore higher consumer prices. Let’s not forget that “inflation targeting” was a politico-economic project launched in the 1980s to tilt the balance of power towards capital at the expense of labour. The wheel may have come full circle. Pandemics have this effect. Finally, as Goodhart and Pradhan remind us in their book The Great Demographic Reversal, Western economies may have no choice but to choose the lesser evil of inflation to reduce the threat of another evil, “debt”.

So, for any USD-INR forecast, higher inflation rates in India compared to the US which has been the default factor for the past decades cannot form the basis. The Fund may need to revise its implied forecast for USD-INR in April 2022.

V. Anantha Nageswaran is Distinguished Visiting Professor of Economics at Krea University. These are the personal opinions of the author.

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