RECORD LOW The Rupee has Fallen Below its Fair Value The rupee was fairly stable around . 54-55 to a dollar between August 2012 and May 2013, and fell sharply to around . 61 in two months. Though the fall reflected a general depreciation of emerging-market currencies, it has sparked a debate on what the equilibrium value of the rupee is. Some commentaries arguing for further depreciation are based on the “inflation differential”. While the nominal rupee should depreciate to maintain competitiveness if Indian inflation is higher than that of its trading partners, the need to depreciate is lower if Indian productivity growth is higher than that of its trading partners. Correcting for the effects of productivity, we find that the rupee is not significantly overvalued today. Competitiveness is only one of the factors determining the current account deficit (CAD). Things like a ban on iron ore output leading to lower exports and higher imports and rigidities in coal output explain much of the high CAD. So does the demand for gold. Now, if large imports like oil are relatively inelastic to depreciation and if there is a rising imported intermediate content of exports, then rupee depreciation is unlikely to squeeze the CAD. In that case, the exchange rate will be determined by financial market perceptions. Given that incorrect expectations may become self-fulfilling, relying on the market to get it right, or to not overshoot, may not be right. The real effective exchange rate (REER) — a weighted average of our currency relative to our trading partners’ currencies, adjusted for inflation — is a common measure of the alignment of a currency to its true value. The RBI’s measure of REER uses the wholesale price index (WPI) for India and consumer price index (CPI) for trading partners, we re-estimated the REER using CPI for India as well, with 2005 as the base year. Our estimate of REER was at an average of 11.4 in July. This means that despite the recent depreciation, the rupee was 11.4% higher than its fair value in July. Based on this, observers say the rupee needs to correct more. But this ignores the fact that the rise in REER might reflect an improvement in productivity vis-à-vis trading partners and, thus, a long-term movement in the equilibrium exchange rate. So, since the equilibrium exchange rate itself is likely to have gone up owing to productivity changes, at the very least, the degree of overvaluation or deviation from the new equilibrium ought to be lower than 11.4%. So, we need to adjust for the productivity differentials when measuring the competitive nominal exchange rate. This was first pointed out by economists Bela Balassa and Paul Samuelson, in the context of developing nations. As poor countries grow and their productivity improves, an appreciating real exchange rate is common. If India’s productivity and thus the wages in the IT services or garment exports rise, then the price of haircuts that are non-tradable services, where there has not been a comparable rise in productivity, will also rise, leading to an economywide rise in prices. This does not mean the country is uncompetitive in the export sector; in fact, quite the contrary. We worked out the equilibrium value for REER during 2005-12, assuming the currency was fairly valued in 2005. Based on data from the World Development Indicators of the World Bank, India’s per-capita dollar GDP in PPP terms increased by around 37% relative to a weighted average of the top six trading partners during 2005-12. Based on that, the equilibrium value for 2012 works out to be 112. So, the REER average for July 2013, at around 111.4, implies that REER for India was close to its long-term equilibrium value in July 2013. However, with the rupee around . 65-66 to a dollar, it has overshot its equilibrium value and is undervalued at current levels. So, after taking into account productivity, wage and price increases in India, we find that the rupee has fallen more than it should have against the dollar. The nominal rupee at July 2013 levels was closer to what it ought to be. The need for a large depreciation based on inflation differentials need not be valid. That is also the conclusion of a new IMF assessment of the economy’s external balances.
Posted on: Wed, 28 Aug 2013 09:55:03 +0000
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