The debate on the real value of the rupee

The real value of the rupee has been a matter of considerable debate. In the last three years, the rupee has suffered two instances of sharp declines. First, from July 2011, for nearly a year, the rupee fell 16%, and then, from May-September 2013, it declined 14%. Both followed periods of elevated inflation, rise in current account deficits, and episodes of (exogenously induced) large capital inflows.

In this context, the real effective exchange rate (REER) is a more reliable basis for assessing the valuation of rupee. It takes into account the trade weighted exchange rate discounted by respective inflation rates, which gives a more accurate measure of the relative competitiveness of an economy with respect to its competitors. Two observations based on data from RBI, BIS and the Bruegel Institute.

1. Despite the persistent high inflation since mid-2009, the REER remains at about the same level today as it was then. In fact, both instances of sharp depreciation followed periods of REER not responding despite inflation remaining elevated for more than a year. Something had to give. Given the high inflation, it is only natural that the volume of goods that can be purchased with the same amount of your currency decline. This was all the more so since among all our major trading partners, India had one of highest inflation rates. The exchange rate had to decline sharply to reflect this.

The first period coincided with the aftermath of the global financial crisis and the flight of capital into emerging economies in search of yield, coupled with a series of seven rate increases at a time when rates were falling elsewhere. The second period coincided with the peak of the third round of quantitative easing in the US and the Eurozone crisis which again triggered another round of capital flight into emerging economies. In both instances, sudden-stops were followed by sharp depreciation.

2. The comparison with its emerging market peers is also important. Compared to most of our competitors, the REER of the rupee remains elevated. Despite the persistent high inflation, the REER of rupee today stands at exactly where it was five years back. Leaving aside China and Brazil, the rupee appears over-valued compared to all other competitors.

In a recent column Arvind Subramanian and Martin Kessler examined the valuation of rupee with respect to Balassa-Samuelson effect (the positive relationship between PPP prices and GDP percapita) and found the rupee under-valued by 30%. In other words, assuming the relationship to hold, the rupee appears 30% under-valued. However, this theoretical approach over-looks an important structural shift in the Indian economy - the near doubling of the share of tradeable sector from 24% of GDP in 2004 to about 43% in 2012. This would have had the effect of attenuating the rise in aggregate price levels due to non-tradeables, thereby minimizing the Balassa Samuleson effect for the period under consideration.

In the circumstances, for atleast the short to medium-term, further declines in the value of rupee may be both desirable as well as forthcoming.