Rupee likely to slide further

The rupee has depreciated significantly from Rs 44 a dollar in August 2011 to more than Rs.55 a dollar on May 21, 2012. The slide of the rupee, which began in August, crossed 54 to a $ in mid-December.

However, there was some gain following RBI intervention in the currency market. Measures were taken to curb speculation and incentivise dollar flows to the economy. Apart from these domestic measures, liquidity infusion by the European Central Bank helped the rupee recover some ground in January and February 2012.

Much hope was pinned on the Budget for some long-pending reform measures and credible fiscal consolidation. But instead of pacifying markets, the Budget announcements on retrospective taxation antagonised foreign investors.

To make matters worse, heightened uncertainty about Greece has led to flow of capital away from India.

Net FII equity flows, which were close to $12 billion in January and February, turned negative in April and May.

It is worth exploring to what extent the rupee can slide and where it will settle. Apart from other measures, the Purchasing Power Parity (PPP) theory provides a simple and elegant view of how exchange rates should be behaving.

PPP Theory

The PPP theory is based on the idea that currencies are in equilibrium when their purchasing power is the same in each of the two countries.

The PPP theory suggests that a currency would appreciate or depreciate vis-à-vis another currency to the extent of the inflation differential between the two countries.

In other words, if in a particular year the inflation in India is 7 per cent and 2 per cent in the US, the rupee should depreciate by 5 per cent against the dollar in that year. PPP serves only as guide; in practice, evolution of the exchange rates is governed by a host of other factors, such as the central bank's intervention in the currency market, hedging and speculation in the currency market, and above all, prevailing sentiments.

What does the PPP theory tell us about rupee-dollar exchange rates? We have taken 1994 as the starting point for computing PPP-based exchange rates.

Computation of the inflation differential is key to determining the exchange rate through the PPP method.

We consider the growth in GDP deflator for US and India between 1994 and 2011 to find out the inflation differential. We have computed the inflation differential in three different ways.

First, by computing the compounded annual growth rate (CAGR) of the GDP deflator between 1994 and 2011. Second, considering the evolution of inflation separately before the onset of the global financial crisis and after it. This demarcation is important as India entered into a much lower growth and higher inflation trajectory after the crisis. Taking into account the changed inflationary path, the entire period is broken up into 1994-2008 and 2009-11. The CAGR of the GDP deflator is computed separately for these two periods and the inflation differential is derived accordingly.

Third, computing the year-on-year growth in GDP deflator in US and India to get the inflation differential and applying the same to get the PPP exchange rates.

Exchange Rate Predictions

What kind of PPP exchange rates do we get for 2012 by applying three different methods of inflation differential?

Under the first method, by applying the uniform inflation differential of 3.1 per cent between 1994 and 2011, we get a PPP exchange rate of Rs. 55.5 per dollar in 2011.

Applying the same inflation differential, the exchange rate should be Rs. 57.2 for 2012.

Using the second method, the annual inflation was 4.9 per cent for the period 1994-2008, but shot up to 9.1 per cent between 2009-11.

As such, when we apply two different inflation differentials, one up to the period 1984-2008 and other between 2009-2011, we get a PPP exchange rate of Rs. 58.4 in 2011.

As per the third method, the application of Y-o-Y inflation differentials gives us PPP exchange rate of Rs. 59.6 in 2011. The exchange rates predicted by the PPP for 2012 as per the second and third methods are Rs. 62.5 and Rs. 63.5, respectively.

Growth Slowdown

A comparison of market exchange rate with that of PPP exchange rates suggests that the rupee is overvalued when economic growth is high, as was the case between 1994-97 and 2004-08.

As growth slackened after 2008, the upwards bias to the rupee got corrected. If the Y-o-Y based inflation differentials are a guide, the market exchange rate will slide further.

Another interesting feature is that the correction of the market exchange rate vis-a-vis the PPP based rates is associated with an external crisis.

In the first case it was the East Asian financial crisis, and in this round it is the global financial crisis.

Growth slowdown following an external crisis puts pressure on the rupee.

Though domestic problems like a ballooning current account deficit, high levels of inflation and lowering of growth are partly responsible for the falling rupee, an equally important factor is global uncertainty.

In such a situation, proactive policy measures should be followed to counter externalities. What we find instead is policy uncertainty and failures in governance, aggravating frayed nerves of foreign investors and leading to a run on the currency.

Unless investors are convinced that the government is taking firm action to promote growth, preventing a further slide would be difficult.

(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)

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