Ashima Goyal

Arriving at a fair value of the rupee

Ashima Goyal | Updated on August 05, 2018

Rupee level India needs to find the fair value of the rupee   -  ISTOCK PHOTO

India must not remove cap on debt inflows in a hurry. A real exchange rate stable at 114-16 will stimulate exports

This year rupee volatility created a buzz because it came after four years of relative stability, and a reversal of the trend appreciation of 2017. In earlier episodes of global-shock-led depreciation in 2008, 2011 and 2013, a major worry was on its impact on the already high inflation. Today inflation is moderate. But after a prolonged slump in trade growth, and in a climate of currency wars, the focus is on the impact on trade.

The real exchange rate

Even in 2004-05 when the index base was changed the level of the real effective exchange rate (REER) was almost the same as it was after the double depreciation following the early nineties’ liberalisation — this was regarded as the export competitive or fair-valued exchange rate since Indian exports had done better in this post-reform period. Even in 2007 the REER was at this level and deviations were only transient. After 2014, however, there was sustained real appreciation, peaking at almost 122 in 2017-18.

But 100 may no longer be the equilibrium or fair value of the REER, because other factors, apart from relative inflation, affect the equilibrium real exchange rates. Rise in Indian relative productivity, real wages and non-traded goods prices imply an appreciated fair value. Problems in the construction of the REER also make it a flawed indicator of competitiveness.

First, in 2014 the consumer price index began to be used for India’s price level, but since consumer price inflation exceeded wholesale price inflation over 2007-15, the REER calculated using CPI was at a more elevated level. The CPI is more relevant for the REER as a measure of the purchasing power of a currency, but WPI with a larger share of traded goods, is more relevant to measure trade competitiveness.

Second, the dollar has a much lower weight in the REER than it has in India’s trade (including in oil) most of which is settled in dollars. So relatively higher current depreciation against the dollar means the relevant real exchange rate is more competitive than the REER. Therefore the rupee may not be 20 per cent overvalued as the REER itself indicates. Overall research shows Indian export growth to be more sensitive to world demand than to the real exchange rate.

Since the exact valuation is contentious, an alternative approach is to examine past levels of REER that were compatible with good export growth and a sustainable CAD. The REER at 115-113 over 2010-12 was consistent with high export growth even in a period of low world export growth. But at the same the level export growth was negative in 2015-16. World exports were booming before 2007 and then finally recovered in 2017, but Indian export growth remained low.

Apart from low world demand, the collapse in oil prices in 2014 also reduced demand for Indian exports partly explaining slow export growth despite real depreciation. In 2016 and 2017 as world export demand recovered, first demonetisation and then the implementation of GST hurt supply, especially from small firms that are the backbone of exports. Signs of recovery in export growth by May 2018 suggest these supply issues are getting resolved.

The REER had also depreciated to 116. Since 115 was consistent with strong double digit export growth even during the global slowdown further real depreciation may not be required. But there must not be sustained appreciation above this level.

Preventing over-valuation

Interventions can affect exchange rate since we are not at a point of a full float and a fully open capital account where monetary policy has no effect on the exchange rate. Despite accusations of currency wars flying around, intervention is also consistent with international laws and conventions, since the Indian exchange rate is not deliberately kept cheap. It is not in India’s interest since it raises import costs and inflation.

After the US abrogated the Bretton Woods agreement on fixed exchange rates in 1976, article IV of the IMF’s Articles of Agreement was amended to allow countries to adopt any exchange rate regime. The only constraint is policies should promote stability and growth, with no manipulation to gain an unfair advantage. But there is no agreed definition of what constitutes currency manipulation.

There are attempts at peer pressure, for example through the G-20, which favours the advanced economy (AE) agenda of no interference in markets, disregarding emerging markets’ defensive needs under capital flow surges and stops due to global shocks. The US Treasury threatens to label a country as a manipulator and pressurise it to appreciate its currency.

A prior step is putting it on a watch-list based on three criteria: a bilateral trade surplus with the US of at least $20 billion, current account surplus of at least 3 per cent of GDP, persistent one-sided FX intervention of at least 2 per cent of GDP over 12 months. A large share of the overall US trade deficit is adequate for inclusion.

India was a new addition in the April 2018 Monitoring List. Its FX purchase of $56 billion came to 2.2 per cent of India’s GDP and bilateral goods trade surplus was $23 billion. But India’s currency has tended to appreciate, not depreciate in the period. Its marginal surplus is nothing compared to China’s, which is above $300 billion. The US Treasury does note India’s overall current account deficit (CAD) and that its currency is not deemed under-valued by the IMF. In its view, however, India does not need more foreign exchange reserves since it still has some capital controls.

Capital flow management

But India needed to intervene more precisely because it relaxed capital controls. Caps on debt flows were lifted. Too much ($19 billion) came in 2017, taking up all space available, because they gained both from India’s much higher interest rates and from currency appreciation.

These inflows did not reduce the cost of government borrowing since the RBI was forced to buy US treasuries at zero interest from the excess inflows it accumulated as reserves rather than buying Indian G-secs through open market operations (OMOs).

Indian G-sec yields shot up to 8 per cent. And the policy repo rate is now being raised partly in fear of debt outflows as the US Fed raises rates. So they do not provide security in CAD financing either.

The RBI will be able to do more OMOs, exit the US watch list, avoid real appreciation, interest rates and the cost of government borrowing will come down, if there are fewer inflows this year. A real exchange rate stable at 114-16 will stimulate exports, and stable oil prices imply the gap in BOP financing will be minor and can easily be financed through reserves. Markets must get used to two-way movement in reserves as well as in exchange rates. Caps on debt inflows must not be lifted too quickly. Six per cent of domestic debt makes them too large as a percentage of foreign liabilities. Their contribution to market development is adequate at lower caps. More stable forms of inflows should be encouraged, instead.

The writer is a part-time member of EAC-PM. The views are personal.

Published on August 05, 2018

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