Busting the myth of rupee over-valuation

One of the unspoken rules in India that everyone accepts, but no one questions is that the rupee should keep depreciating, year after year. Ever since the economic liberalisation in 1991, when the currency was devalued, the rupee has lost an average of 4 per cent every year against the green-back.

The justification given for this consistent decline is the sustained trade deficit and inadequate forex reserves. There has also been a constant refrain that the rupee is overvalued and needs to depreciate further to increase its export competitiveness. A metric used to fortify the case for allowing the rupee to depreciate is the Real Effective Exchange Rate of the rupee.

The REER is the standard measure used globally to gauge the value of the home currency against the weighted average value of the currencies of its trading partners divided by a price deflator or index. REER above 100 denotes that the home currency is overvalued and more expensive compared to its competitors.

The 36-currency trade weighted REER computed by the RBI had ruled around the 100 mark prior to the global financial crisis in 2007-08. But since then, it has been featuring well above the 100 mark; moving close to 120 in 2017-18. This had been used to show that the rupee was overvalued against its trading partners and that it was hurting our exports. But the overvaluation depicted by the old series of the REER was due to certain shortcomings in the computation methodology. In January this year, the RBI released the new series of REER, which seems to reflect the true state of affairs — that rupee is not overvalued and does not need to keep slipping lower forever. The levels indicated by the new series are also closer to the rupee REER disseminated by BIS, which show that the rupee is rightly valued.

What has changed?

The RBI disseminates six currency and 36 currency based trade weighted and export weighted REER and NEER (Nominal Effective Exchange Rate which is REER not adjusted for inflation). The previous series had 2004-05 as the base year. With the economy and trading partners changing significantly since then, a review of the index was overdue.

The new series of REER released in January 2021 has the base year as 2015-16, which is considered a normal year based on macro parameters. The basket for the broad index has been expanded from 36 to 40 currencies. The computation of trade weights has also been improved — by basing it on three-year arithmetic means of trade flows around the base year. Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania, and Ukraine have been included in the broad NEER/REER while Argentina, Pakistan, the Philippines, and Sweden exit the basket. The new basket represents 88 per cent of India’s total trade as against 84 per cent in the earlier 36-currency basket.

While the changes are good, a few shortcomings still remain. One, the selection of trading partners is based on overall merchandise trade whereas it is better to consider trade in manufactured goods alone. The REER computed by BIS for instance considers only import and export of manufactured goods as export competitiveness needs to be gauged in only these value added items.

Two, it is not clear if the new REER series has addressed trans-shipment effect. If this was done, the weight for the UAE may have been lower. Three, adjustments for third market completion (wherein weights are modified to take in to account countries that are trading partners as well as export competitors in other markets) would have resulted in higher weights for other Asian and EM countries and lower weight for Euro area. This could have made the rupee REER more effective.

Is the new series better?

That said, the new REER appears to be a vast improvement on the previous series in depicting the rupee’s over/under valuation. The new trade-weighted REER did not cross above 100 in the period between April 2004 and February 2015, it mostly ruled between 90 and 100. While the index has moved above 100 since then, the overvaluation was limited to 7 per cent. In contrast, the old series has shown the rupee as being consistently overvalued since 2008. (see graph).

The over-valuation depicted by the old series was at odds with the rupee REER computed by BIS as well as the movement of the rupee exchange rate vis-à-vis other emerging market currencies. The REER for rupee computed by BIS has depicted the rupee as being rightly valued or slightly undervalued for most part since 2004-05. In fact the values of the RBI’s new series are far more in sync with the BIS values.

Another metric that shows us that the rupee is not overvalued, is the cross-currency comparison of currencies against IMF’s SDR. Currently 1 SDR equals 105 rupee. The value of rupee is far lower compared with currencies of other emerging economies such as China (9.3), Brazil (7.9), Malaysia (5.9) and the Philippines (69.2). The continuing depreciation in rupee over the years seem to have made it quite competitive against its peers.

Policy implications

The RBI has maintained that its intention is to maintain stability in the rupee movement and not to target any specific level for the exchange rate. The new series of the RBI and the BIS REER show that this strategy of the RBI, coupled with inflation targeting have helped the rupee stay competitive in the export markets.

While this strategy can continue, constant demands to weaken the rupee to help exports need not be heeded. For it is clear that rupee is quite competitively valued and the reasons for sluggish exports lie elsewhere. On the other hand, a weak currency has been hurting our importers and hurting profit margins of companies, besides being inflationary. Also foreign investors tend to think twice about investing in a country with a currency that is on a downward spiral. For the return on their holding tends to erode with fall in currency value. It is probably time to rethink the policy of allowing the rupee to slide ceaselessly.

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