Using the foreign exchange reserves to defend the rupee on a sustained basis should be avoided
RBI Watch Indian Rupee
Below are the usual two tables I produce each month - the idea being to see how the rupee has performed not just against the US Dollar, which can be misleading, but against a basket of currencies. Why? When we look at inflation in India, do we measure it by just what has happened in the price of a mobile phone? No, to get the correct picture we measure inflation against a basket of goods typically consumed by a household in India.
I emphasize this because a few days ago the
rupee fell against the US dollar to 67 rupees, a level last seen in August
2013, when worries about India's burgeoning current account deficit pushed the
rupee to a historic low of 68.4. The rupee has fallen by over 7% against the
US dollar in the last year. Most of this fall has occurred this financial
year – a fall of 6%.
But let's see how the rupee has
performed against a basket of currencies, representative of the countries
India trades with actively.
The Reserve Bank of India publishes this data
every month. I use that data for creating my monthly tables.
Against
a basket of currencies (Net Effective Exchange Rate), the rupee has actually
strengthened by about 1% over the last one year. However, during the current
financial year - in India we start this on April 1 - the rupee has fallen by
about 3%. This is a remarkable performance considering that over the last one
year most emerging market currencies have fallen sharply - many to record lows.
To
get the full picture lets also look at the rupee in real terms (Real Effective
Exchange Rate), after adjusting for inflation with India's principal trading
partners. By this measure, over the last one year the rupee strengthened by 3%.
During the current financial year, the rupee in real terms has fallen, but by a
negligible 0.2%. The bottom line is that in real terms the rupee continues to
be overvalued - an index level of 100 suggests that the rupee is somewhat
fairly valued, and many consider an index level above 110, a 10% overvaluation,
a case of significant overvaluation.
Overvaluation
can persist for long periods of time. I would be really concerned if the index,
REER, was in the 120 range.
The
picture of the rupee suggests that, on balance, economic agents – domestic and
foreign – have confidence in the currency. India has seen foreigners invest more
in India – both in setting up factories and services as well as investing in
India’s financial markets, such as bonds and equities. From a trade
perspective, the picture has not been rosy. Weak world growth and a slowing
economy at home have seen significant declines in exports and imports. India’s
current account deficit is low and manageable, but one that comes from falling
exports and imports is less positive than a higher current account deficit,
which results from a rise in exports and imports, in my view
A
more competitive rupee would be a bonus for the country.
The
Federal Reserve has announced two days ago a rise in the target federal funds
rate. Interest rates are expected to rise in the USA in 2016. There could be
some unexpected twists in the world’s financial markets and economy next year.
The
RBI could be well served to avoid the temptation to use India’s foreign
exchange reserves to defend the rupee on a sustained basis. Although India’s reserves have increased, the truth is that any
amount of reserves in not enough. Look at China sitting on 3.4 trillion dollars
of reserves. In two months in the recent past, reserves fell by more than a
whopping 80 billion dollars – last month the fall was $87 billion, and in August
it was $ 94 billion!
