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Valuation of currencies is still an inexact science, partly due to excessive narrowing down of economic models which make unrealistic assumptions like the law of one price and ignore international monetary hierarchy. Alluding to the problem in a recent interview with the Institute for New Economic Thinking, former RBI governor Raghuram Rajan said, “You shouldn’t narrow down so much that you miss some of the bigger pieces that you’ve left out. NITI Aayog Vice-chairman Rajiv Kumar recently told reporters that the Indian rupee was overvalued by 5-7%. Since then, several experts have claimed that the rupee is overvalued by around 15%. At the same time, other reports claim that the rupee is actually undervalued by around 10%. Why is there such a stark difference of opinion regarding the valuation of India’s currency? More importantly, is the rupee undervalued or overvalued? To understand that, we need to delve deeper into a key variable in international economics: the real effective exchange rate (REER). What is REER?
The real exchange rate calculates the purchasing power of a currency by adjusting the nominal exchange rate for inflation effects. It measures the number of units of a domestic good you have to pay to buy one unit of the equivalent foreign good. While nominal exchange rate focuses on the exchange of money, real exchange rate focuses on the exchange of goods and services (US goods vs Indian goods). To put it simply, REER is an indicator of the competitiveness of a country’s currency with respect to a basket of currencies, adjusted for inflation effects. India’s REER is measured as a weighted average of India’s bilateral real exchange rates with all the countries in the basket. Thus, REER has two components: (i) real exchange rates and (ii) weights assigned to each currency. The second component, weights, depends on the importance of the countries in the currency basket as India’s trading partners. For each foreign country, the weight represents its share in the trade which India conducts with all the countries in the basket. In April 2014, the Reserve Bank of India (RBI) released a circular which mentioned that its 36-currency trade-weighted REER index assigns a weight of 8.8% for the dollar.
The two biases
Further, a puritanical reading of REER is complexed by two biases.The first bias emerges from changes in relative productivity between India and other countries in the basket. According to the Harrod-Balassa-Samuelson effect, a rise in productivity in the tradable goods sector leads to an appreciation of REER (through wage increases in the non-tradable sector).However, since this REER appreciation is assumed to have no effect on trade competitiveness (due to law of one price), it creates a bias in REER. The productivity-adjusted REER is currently around 90, which implies that the rupee is undervalued by 10%. The second bias exists because REER ignores the hierarchical nature of the international monetary system. It assigns weights to different currencies based on the amount of bilateral trade between India and the respective countries, not based on the share of each currency in India’s total trade payments. Given the dominance of the dollar as the world’s reserve currency, a disproportionate share of global trade is priced and settled in dollars, especially in commodities such as crude oil. In 2016, 80% of India’s trade was settled in dollars, according to the inter-bank settlement system, SWIFT.However, the weight of the dollar in REER is only 8.8%. This under-weighting of the dollar leads to a bias in REER, which the productivity-adjusted REER does not correct for: overestimation of the aggregate strength of the rupee when it depreciates against the dollar. A further adjustment for the hierarchy bias suggests that the rupee is undervalued by more than 10%. The hierarchy bias is particularly important right now since the rupee depreciation against the dollar, combined with rising oil prices, has increased India’s import bill (paid in dollars). But, despite the depreciation, export growth continues to be weak because of rising protectionism, sluggishly recovering global growth and disruption of domestic supply chains in the last two years. This view of trade and rupee valuation supports recent actions of the Reserve Bank of India to arrest the depreciation of the rupee against the dollar using foreign exchange reserves. Calls to let the rupee depreciate further might need closer examination.
How does it matter?
Policy decisions affect various groups differently. As noted by the economic survey 2017-18, the table below lists below the preferences of different groups in relation to interest and exchange rates, as well as the underlying reasons. For example, strong exchange rates may be preferred by companies that sell non-tradeables and rely on imports for their inputs: the classic case here is power companies that sell electricity to domestic distribution companies and import their capital equipment. Conversely, services exporters such as IT companies will be keen on competitive exchange rates because they sell mainly abroad, while importing very little. A strong exchange rate is preferred by those who equate currency strength with broader national strength.
Morevover, Economies live in society and hence the economists need to account for financial, social, and political factors to get a better grasp of how economies actually work. The only way to improve our understanding of currency valuation is to broaden existing models and incorporate the financial, social and political realities of our world and its societies.
By: Abhishek Sharma ProfileResourcesReport error
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