Reer, Ppp And The Alphabet Soup

What is perhaps most refreshing about their response is that it reasons out the establishment point of view, based on appropriate theoretical insights. This is quite in contrast with the usual RBI response to promote monochromatic views that either reflect its own opinion or are supportive of its own stand, and rubbish all others that take a contra position.

A modicum of protest against the RBIs REER-based quasi-targeting approach was long overdue. We use the term quasi-targeting because the RBI does not target a particular level of the exchange rate nor does it have a stated target band around a particular level. Yet, through its actions and in official documents it has propounded the line that while it will resist an appreciation in the REER, it will not fight market forces working their way towards a depreciation.

 

This has to be tempered with a cautionary note, often reiterated by the central bank that it will not allow the nominal exchange rate to stray too far from the levels dictated by the REER. Simply stated, this means that the RBIs has specific levels of tolerance, though the levels may be skewed less on one side (when REER is appreciating) than the other.

The unstated construct is that some kind of a band influences the RBI actions, though explicit targeting has often been ruled out: we have seen in recent times that the RBI even let the REER appreciate to more than 14 per cent by August 1997 (over the base period set at March 1993). The Committee on Capital Account Convertibility, of course, recommended an explicit targeting mechanism of a band of +/-5 per cent around the REER.

The fundamental problem with REER is that it focuses on only one active variable: the relative price movements in the goods markets of the two countries, that is the inflation differential. This can be illustrated using the basic and most popular construct of a McDonalds burger. Assume that the price of a burger at some base level was $1 in the US and Rs 30 in India. Purchasing power parity (PPP) requires that the exchange rate should settle at $1=Rs 30. Now assume further that in the course of one year, the inflation rate in the US was 4 per cent and 8 per cent in India. That is, a burger should now cost $1.04 in the US and Rs 32.40 in India. This reflects in a real effective exchange rate of $1.04=Rs 32.40 or $1= Rs 31.15.

But as the early flexible price monetary models (Rudiger Dornbushs sticky price model (1987), for instance) show so clearly, inflation is but one of the many variables that impact exchange rate dynamics. Dornbush showed that relative money supply growth, real interest rate and income growth rates enter the exchange rate equation, accounting for the fact that since wages and prices are sticky in the short-run, there may be significant overshooting of both the real and nominal exchange rates from the long run equilibrium.

But in drawing upon continuous PPP, the REER-based models fail to capture other variables. Thus, in times of significant capital inflows, the nominal exchange rate will appreciate and thereby show a wider divergence from the REER. Attempts to pull down the nominal rates to levels dictated by the REER in the short period could lead to a destabilising over-depreciation in the nominal exchange rate.

A substantial body of recent research shows that though PPP holds in the long term that is, the system reverts to REER-determined levels the short period movements of the exchange rate may stray far (Niso Abuaf and Phillipe Jorian, Purchasing power parity in the long run, Journal of Finance, Vol 45, March 1990; Yoonbai Kim, Purchasing power parity in the long run-a cointegration approach, Journal of Money, Credit and Banking, Vol 22, November 1990; and James R Lothian and Mark P Taylor,Real exchange rate behavior..., Journal of Political Economy, Vol 104, June 1996). Hamid Faruqee (Long run determinants of the exchange rate: A stock-flow perspective, IMF Staff Papers, Vol 42(1), March 1995) concludes that the deviations from PPP may last a very long time, although they do not certainly follow a random walk...The dynamic process is mean reverting.

However in the short run, policies to keep the real exchange rate constant in the face of exogenous real disturbances may prevent the establishment of a macroeconomic equilibrium and hence may be destabilising, (Peter J Monteil and Jonathan D Ostry, IMF Staff Papers, Vol 38(4), December 1991).

The other set of problems with REER arises from the fact that it is hostage to the statistical construction of international competitiveness behind it. The RBI, for example, computes two series, one based on 36-country bilateral export weights while the other uses 36-country bilateral trade weights. Worse, as The Eklavyas point out, the problem with working with lagged data on inflation rates in the other countries on the one hand and current exchange rate levels on the other is inconsistent. For instance, we are still working on assumptions of REER divergence based on September 1997 indices, which are a full four months outdated. This is something that cannot be speeded up, for the simple reason that data generation in the primary countries of interest itself involves a time lag, compounded by delays in publication and dissemination.

Instead of tackling the problem head-on, the RBIs Currency and Finance Report for 1996-97 had in fact suggested a panel of REER measures, each one of them obviously targeting a different view on international competitiveness, or perhaps a simple PPP-based model adjusted for various contra-pressures acting on the exchange rate. This is clearly a compromise solution, driven by the imperative to junk the historical REER construct but not yet clear on what to replace it with.

But perhaps there is merit in making some improvements to the historical REER construct. For one, misalignment in the exchange rate to the extent that the overvaluation reflects stress on the countrys export competitiveness is a good proxy variable in predicting currency crises. Intuitively, the position is simple: with a country running an overvaluation of the REER and under stress agents can always figure out that the authorities will at some point in time either devalue the currency outrightly (in case of fixed exchange regimes) or engineer a downward adjustment in the exchange rate. And as literature on speculative attacks shows, agents will always press a speculative attack whenever they think it is profitable to do so.

That is, speculators will always precipitate a crisis knowing fully well that the country, though willing to depreciate its currency, will not be able to put up a sustained defence either due to the constraint of its reserves or due to political restraints that rule out the kind of defence mechanisms that are required to contain an exchange rate overshooting.

In two recent papers, Ilan Goldfagn and Rodrigo O Valdes (The aftermath of appreciations, NBER Working Paper 5650, 1996 and Are currency crises predictable, IMF Working Paper 159, December 1997) argue that the REER enters the expectations formation process as a useful summary variable, and therefore overvaluation has good predictive power in explaining such (currency) crises.

To that extent, we need to get a good grasp of the extent of over- or under valuation. The issue however at this point is that even if we know the extent of overvaluation, the tools available to correct the position in the short term are limited.

We come back again to the same dilemma as for the REER as a proxy for overvaluation: what can one do about it other than to nudge the currency lower? But if usefulness of REER, or for that matter, any other measure of international competitiveness, as a direct policy variable is suspect, there is absolutely no point in putting it centrestage as a target variable.