Concern with rupee overvaluation

Given that inflation is likely to rise over the year, the rupee needs to depreciate

The sharp and somewhat unanticipated appreciation in the rupee over the last few weeks has revived fears that a bloated exchange rate could be yet another thing that could rein in exports and growth. Those who go by the traditional six-country real effective exchange rate (REER), a weighted basket of exchange rates vis-à-vis major trading partners (the developed world heavyweights and China) could be getting their share of night sweats. Going by this index that has 2004-05 as its base year, the rupee was overvalued by a hefty 27 per cent in February (the latest available data point). The Reserve Bank of India (RBI) also computes a 36-country index that takes into account competitors as well that showed a smaller but substantial overvaluation of 16 per cent. Both indices would have gone up sharply in March as the rupee-dollar rate went up by 2.6 per cent.

The question: are these the right metrics to use? A popular argument is that what really matters for the currency is how it has fared vis-à-vis its competitors, not its major buyers. The “over-valuation” picture looks somewhat different if viewed from this angle. The 2016-17 Economic Survey tried to do this by assigning higher weights to Asian competitor currencies and found eight per cent overvaluation for October. We attempted to extrapolate this forward and for February found about seven-eight per cent overvaluation. The index remained steady largely due to waning inflation differential between India and others as retail inflation collapsed. Not much harm done then, especially if you assume that we’ve seen marginally higher productivity growth than the others in this period.

Does the sharp rise in our currency in March make a difference then to our competitiveness? For one thing, the gain was not in isolation. An index computed for emerging market currencies showed a gain of 1.4 per cent. To take specific examples, the Russian rouble went up by about 2.6 per cent and the Thai baht by 1.6 per cent. The appreciation happened across the board as currency holders, spooked by the Trump administration’s failure to push its first major piece of legislation (repealing Obamacare) through Congress, dumped US dollars.

That said, the rupee did outperform all its emerging market peers and clearly the state election results added to the momentum. Should the RBI have intervened more vigorously to prevent this “excess appreciation”? Perhaps not. We can think of a couple of reasons to make our case. For one thing, it is useful to remember that stopping the rupee’s rise would entail buying dollars and releasing rupees into the market. Given the massive excess liquidity in the market that has emerged from demonetisation-driven deposit build-up and weak credit demand, the scope for releasing more cash in the market without seriously distorting money and bond market rates was limited.

There was another important fallout. Over the last few months, markets had come to believe that the RBI was fixated with keeping the rupee in a very tight band. This translated into a lack of incentive for hedging. The RBI’s decision to allow the rupee to gain should drive market participants to question this belief and cover their positions.

But where is the rupee headed? Should it appreciate or depreciate? As we write post Thursday’s monetary policy, the rupee has appreciated further partly on the back of the RBI’s assertion that with the strong flows that are coming in, some more appreciation is possible. But what goes up must come down.

The key to the rupee’s reversal is a rebound in the dollar. For one, most analysts agree that that the American currency is hugely oversold. Besides, if we go by the conventional logic of politics, Trump should be getting ready with a strong counteroffensive to make up for the Obamacare fiasco. That should be positive for the dollar, take some capital away from overheated markets (India might just qualify) and drive some depreciation in the rupee. 

Does the rupee need to depreciate going forward? Clearly yes. Inflation is likely to rise over the year and push the inflation wedge between us and our competitors up. The rupee might have to shed some weight to make up for this. This would help exporters and prevent market participants from taking risky, one-way bets on the currency.

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII