It is now certain that a sustained recovery of the US economy requires a depreciation of the dollar particularly against the Chinese yuan. The sharp fall in domestic consumption in the US that occurred following the crisis has to be offset by a rise in net exports. This is proving to be difficult as the Chinese resist a yuan appreciation through massive intervention in the currency markets. The disastrous effects of G-7 managed appreciation of the yen in mid-eighties on the Japanese have made the Chinese wary of the possible effects of a sharp appreciation in the yuan. What about the rupee?

The rupee has been appreciating against the dollar since March 2009. It appreciated from Rs.51.75 per dollar in mid-March 2009 to Rs.46.29 per dollar at the end of January 2010, i.e., by almost 12 per cent.  This appreciation was triggered by the resumption of foreign capital inflows into the country since March 2009 (chart 1). Trends so far indicate that the country will end up with a current account deficit equal to about 2 per cent of GDP in 2009-10. In this context, it is pertinent to ask whether the Indian rupee is appropriately valued now.
Chart 1: Rupee Appreciates as Foreign Exchange Reserves Build up

Source: Reserve Bank of India.

One way of judging whether a currency is in tune with fundamentals is by looking at the trends in its real effective exchange rate (REER). The Reserve Bank of India has been computing the real effective exchange rate of the rupee based on a 36-currency basket, which represents 47 major trading partner countries of India (including 12 countries belonging to the euro area).  These countries accounted for about 89 per cent of India’s exports during the three-year period, 2002-05. The REER is the nominal effective exchange rate (NEER) adjusted for the relative price differential between India and these countries. The NEER is a weighted average of nominal bilateral exchange rates of India against its major trading partner countries. To calculate relative prices, the Reserve Bank uses the wholesale price index (WPI) for India and consumer price indices for other countries. This is incorrect. We have reconstructed an alternative REER for India using India’s consumer price index (CPI).  This makes a significant difference as can be seen in Chart 2.

Chart 2:  Index of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) for the Rupee
(36-Currency Export Weighted, Base: 2004-05=100)

Source: Authors own calculation based on data from IFS, IMF and DGCI&S.

In 2004-05, India’s current account was nearly in balance with a current account deficit of just 0.4 per cent of GDP. We can say that the rupee was in equilibrium that year. After touching a peak in 2007-08, the REER fell during the crisis period in 2008-09. However, it has been moving up again since March 2009. By November 2009, it had broken the equilibrium value and become overvalued to the extent of about 9 per cent. The REER computed using India’s WPI is a gross underestimate and wrongly gives the impression of an undervaluation of the rupee.

The fact is that India has been losing export competitiveness in recent months. This is partly due to the nominal appreciation of the rupee and partly due to high inflation. As exports have started to grow globally after a long period of sharp contraction, it is important that we maintain a competitive exchange rate. This consideration has to be taken into account in the central bank’s policy as it begins its tightening cycle.