As India Knowledge at Wharton recently reported, many Indian companies and industry organizations — especially those that are export-oriented — have been complaining about the strong rupee’s negative effects on their operations. Some have urged the Reserve Bank of India to intervene. Jitendra V. Singh of Wharton’s management department — who takes over as dean of Singapore’s Nanyang Business School on September 1 — has a different view. In this opinion piece, Singh argues that Indian firms should use the rupee’s strength to their advantage by adapting their business models in innovative ways, much as Japan’s automakers did during the 1980s.
For as long as I can remember, the rupee has steadily depreciated against the dollar. In the early to mid-1970s, the exchange rate was 7:50 rupees to the dollar, and the long-term decline continued for the next 25 to 30 years until the rupee reached 49 to the dollar in May 2002. One colleague of mine, a prominent economist, had predicted that the Indian currency would continue to drop until the exchange rate went to 100 rupees to a dollar. Until now, he has been proved wrong. Recently, for the first time in at least three decades, the rupee has begun to appreciate. That does not surprise me. In the next 15 to 20 years, it is possible that the rupee may again reach 15 to the dollar, as it was during the 1980s.
How does the stronger rupee affect Indian firms? Clearly, the rising currency has both pros and cons — some companies suffer while others benefit. These days, we have been hearing many complaints from companies that are hurt by the rising rupee. Companies with business models whose revenues are generated in dollars — and whose costs are denominated in rupees — are worse off. For instance, growth and profits are slowing down at IT companies because of increasing rupee costs as well as wage inflation. Some IT companies, such as Tata Consultancy Services, have implemented complex hedging strategies to deal with the strengthening rupee. When you buy options or futures to hedge against currency appreciation, that does protect you — but you also have to bear the costs of those derivatives.
In contrast, the rising rupee also helps companies that buy dollar-denominated resources, such as oil from global markets, or those that want to acquire foreign assets. Many Indian companies have recently bought overseas firms. For example, the Tata Group’s Taj Hotels, Resorts and Palaces bought the Boston Ritz-Carlton for $170 million, and there have been reports of other companies such as Tata Motors or Mahindra and Mahindra seeking to take over Ford’s premium Jaguar and Land Rover brands. Companies that make such acquisitions will get a better price because of the stronger rupee. On a $1.5 billion transaction, a 10% drop in price due to a better exchange rate can mean savings of $150 million — which is hardly a small amount. To generate that much additional net profit could require several billion dollars of additional revenues. A weak rupee may be better for exporters, but a strong rupee greatly benefits acquirers and resource buyers. While claims may be made by some that India is better off with a weaker currency, the overall picture is somewhat more complex.
With all this as background, I would like to suggest a strategy for Indian companies to deal with the stronger rupee. They should start by recognizing that the strength of the currency reflects the increasing strength of the Indian economy. The exchange rate depends in complex ways upon a host of factors: flows of foreign funds, interest rates, budget deficits, foreign reserves and trade balances. Just as China’s strong economic growth tended to push the value of China’s currency upwards, we have in India a similar situation. China’s economic growth strategy is primarily export-led, so it makes sense that it is interested in a weak yuan (just as the U.S., trying to minimize its trade imbalance with China, keeps pushing for a stronger yuan). With a multiple set of objectives, which include containing inflation and favoring foreign portfolio and direct investment, the Reserve Bank of India can try to stabilize the currency if there are more buyers than sellers of the rupee, but it may not be able to intervene beyond a point. My view is that the long-term trajectory of the rupee will continue upwards because the Indian economy should remain strong. After all, when the economy was liberalized in the early 1990s, no one would have imagined that India would one day have foreign exchange reserves of almost $230 billion, as it did earlier this month.
Lessons from Japan
The situation that Indian companies face today is broadly similar to that faced by Japanese firms when the yen began to appreciate against the dollar during the 1980s. When I first went to Japan in 1981, the yen was almost 225 to the dollar. But in later years, the yen appreciated to close to 80 to the dollar. Yet companies like Toyota, even as the yen grew stronger against the dollar, saw their U.S. market share go higher. How did they manage that, and what lessons does it hold for Indian firms?
I believe there is a strong parallel here from which Indian companies — especially, though not solely, the IT firms — can learn some important lessons. If Indian companies compete mainly on cost arbitrage, they will find that as their costs rise because of the stronger rupee, they will increasingly become less profitable. Of course, it is also the case that, as the rupee appreciates, net margins at some companies erode more than at other firms. Specifically, if Indian IT companies compete as low-cost providers of IT services, their competitive advantage will erode in a regime of rupee strengthening.
Instead, Indian firms should take advantage of this opportunity to adapt their business models. How can they do that? While the details of the two industries are quite different, the Japanese automobile industry can suggest some answers. Consider what leading Japanese firms like Toyota did as the yen strengthened against the dollar. For product lines where they made the highest margins, such as the Lexus, they continued production in Japan. However, for lower-priced models — where their profit margins were lower and would have been eroded further by the rising yen — they moved production to the U.S. They protected their margins on non-premium products by moving production — and therefore shifting costs — into dollar-denominated areas. They also reduced their vulnerability to further appreciation of the yen.
You may remember that during the 1980s, Japanese auto makers were facing a protectionist backlash in the U.S., and they were subjected to import quotas. Their strategy of moving production of lower-priced/lower-profit cars into the U.S. paid off in a couple of different ways. First, they were able to shift yen-denominated costs into dollars. Second, this was a quite savvy political move, because although these companies continued to gain market share in the U.S., there was little pressure to shut down their plants. Doing so would have meant a loss of American jobs.
I believe Indian companies should take a similar approach in response to this recent rising rupee regime. They need to consider how to adapt their business models. To the extent that they compete primarily on cost arbitrage, the rising rupee will work against them. One key question to ask is how to develop other sources of competitive advantage, such as building high-level capabilities which cannot easily be replicated by competitors, or how to change the mix of activities carried out in India versus other countries. Of course, in order to do this, they will have to change their mindset: They will have to stop thinking of themselves as Indian companies and think more like global companies of Indian origin. They will need to analyze their portfolio of costs and move production to where it makes the most economic sense. Notably, Indian IT firms are trying to address rising wage costs by moving production within India to lower cost regions — Eastern India (Kolkata, Bhubaneshwar) and to Tier II and Tier III towns. However, this will only offset a rising rupee to a limited extent, since the costs will still be in rupees.
If Indian firms were to follow this approach, there would be less reason to use the RBI to intervene to force the rupee down against the dollar. No central bank likes to make big interventions; at best, its role should be to help bring about an orderly transition between shifts in exchange rates.
In the long run, India will be better off with a stronger currency. Indeed, it may be inevitable. The notion that the RBI can keep the rupee down may not amount in the long term to more than wishful thinking. The RBI cannot keep the rupee weak indefinitely; the rupee cannot stay down if the Indian economy is strong and the fundamentals keep pushing it up. Instead, Indian companies should learn to use the strength of the rupee to their advantage by adapting their business models and geographical mix in innovative ways.