The Hindu Business Line : Exchange rate: The real and unreal

THE discussions in the financial press on the valuation of the rupee in the forex market are often based on the concept of the Real Exchange Rate (RER) with further refinements such as the Real Effective Exchange Rate (REER). It takes into account the relative inflation rates as between countries to decide whether a currency is overvalued or undervalued.

It was one of the criteria used by the RBI in deciding on the downward adjustment or devaluation of the rupee in two stages on July 1 and 3, 1991 working out to 17.38 per cent in relation to the then intervention currency — pound sterling.

Although the estimates were compiled initially for internal use, the Bank later started publishing them in the Reserve Bank of India Bulletin. However, the REER criterion has since been given up by the central bank. It does not find a place in its annual report and does not get the same importance as before in international economic institutions. This is understandable.

The purchasing power parity (PPP) theory is the basis for the concept of RER. This theory states that, in free markets, the exchange rates of currencies are determined by their relative purchasing power.

Thus, it says that the rate between two currencies, say, the dollar and the rupee, equals the ratio between the price levels in the US and India. Prices in each country may be measured by an appropriate price index, usually the one for consumer goods.

In the first place, there is not enough empirical evidence to support a consensus among experts in support of PPP, as could be observed from academic studies in professional journals.

Second, even if were true, it would be relevant only when the exchange rate movements are influenced by the trends in the current account of balance of payments. This is no longer true. The total value of annual transactions in world trade is a negligible proportion of the turnover in forex markets.

Today, the exchange rates in many countries, including India, are driven by the capital account. Interest rates, expected yields from investments and arbitrage opportunities play an important role in the markets.

It is wrong to draw any conclusion on the appropriateness of the exchange rate of the rupee on the basis of REER, which is not reliable. It is as good, or as bad, as the Big Mac Hamburger Standard of The Economist for finding out whether a currency is under- or over-valued!

The problem in the construction of the REER is in finding the right base year in which the purchasing powers of the currencies were on a par. The proliferation of REER indices based on different base years published in the Bulletin does not help the analyst in drawing any firm inference. It might have served a purpose in the past; it no longer does so.

In the early 1960s when a dollar officially fetched around Rs 5, I found, as a student in the US, that it could purchase there only what a rupee could in India! In other words, the rupee was very much undervalued in terms of purchasing power.

My periodical visits to the US since then have confirmed that the rupee continues to be undervalued.

This is true also of European currencies (now mainly the euro) and the Japanese yen. In Frankfurt, I found the hotel tariff even for a small room in an ordinary hotel and the prices of other things unconscionably high.

Still an official of the central bank in France who met me in a conference at the Bundesbank told me that he always bought consumer goods in Frankfurt whenever he came there because they were less expensive than in Paris! It was partly due to the high value-added tax prevailing in France.

Foreigners and non-resident Indians from developed nations visiting India get a pleasant shock to find how inexpensive goods and services are in the country.

Those who say that Indian goods are priced out of the foreign markets because of rupee appreciation should select a representative basket of export goods and services and compare, item by item, the prices there of those locally produced and those imported from India and third countries. It will tell a story different from what is claimed by exporters.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India.)