Indian exports likely to lose edge on rising rupee, says RBI study

Study suggests absorbing inflows to avoid this; effective exchange rate index revamped

Indian exports risk losing competitiveness as large capital inflows can cause the rupee to appreciate, says a Reserve Bank of India (RBI) study. Absorbing the inflows through current account deficit and mopping them up as foreign exchange (forex) reserves can help avoid such a situation. The rupee settled at a near five-month high of 72.99 against the US dollar on Thursday after adding 6 paise, strengthening for the third day in a row.

India saw massive foreign capital inflows last year, mainly driven by the huge liquidity in global markets. Central banks have adopted ultra-lose monetary policies to battle the economic disruptions caused by the Covid-19 pandemic.

The RBI’s capital absorption activity has stayed elevated, adding over $124 billion to the country’s forex reserves in 2020.

The inflation differential between India and its major trading partners has fallen and stabilised since the adoption of the flexible inflation targeting (FIT) framework. This bodes well for India’s external competitiveness. India adopted FIT in 2016.

The average consumer price index-based inflation rate declined to below 4 per cent during 2017-18 to 2019-20, from more than 8 per cent during 2009-10 to 2015-16 (pre-FIT regime), the RBI study pointed out.

The RBI has also revised the effective exchange rate (EER) index, the barometer of an economy’s external competitiveness.

It has expanded the basket of currencies from 36 to 40 after replacing four currencies. Since the global trade environment is undergoing a shift, it is important that the nominal EER/real EER basket of the rupee is reviewed regularly.

For policymakers, the movement in REER serves as a useful guidepost to the overall misalignment of the exchange rate of home currency.

In fact, the issue relating to under and overvaluation of currencies has been at the core of several global trade disputes. In the case of India, the relative importance of trading partners has shifted mainly towards emerging markets and developing economies since 2004-05.

Taking cognizance of these factors, the broad basket of NEER/REER indices of the rupee has been expanded from 36 to 40 and rebased to 2015-16.

The evolution of bilateral trade shares of major trading partners warranted the inclusion of eight new countries in the 40-currency basket. These countries added are Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania, and Ukraine. Argentina, Pakistan, Philippines, and Sweden were the countries replaced.

The eight new entrants accounted for 5.4 per cent of India’s total merchandise trade against 1.4 per cent by the exiting countries.

The new NEER/REER basket represents 88 per cent of India’s total trade compared to 84 per cent in the case of the 36-currency basket.