The real value of Indian rupee

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The real value of Indian rupee

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• The declining rupee: As the rupee breached 70 to the dollar mark, importers got jittery. As our CAD widens, and inflation gets imported, concern for the wider economy also arises. The question is : is this depreciation much-awaited, or not?
• Exporters’ logic: They say that INR is not competitive enough compared to trading partners. They claim that the REER (Real Effective Exchange Rate) shows that INR is overvalued compared to trading partners.
• Shortcomings in the EER methodology of RBI: The Effective Exchange Rate method used by RBI is not perfect. The REER of RBI was 115, but if RBI takes into account the technological changes and labour prices in developing nations, it’ll go down.
• General rule: If the REER or NEER > 100, then the currency is not competitive. Below 100, it is. The INR’s REER as found by the BIS (Bank of International Settlements) was 100.3 which is near equilibrium.
• Another fact: Over the past 14 years, the INR has been the worst performing of the emerging market currencies. So how can the REER be overvalued?
• What it does? Any EER captures the movement of INR compared to a basket of currencies of our trade partners. The NEER (Nominal EER) captures the exchange rate changes only, but REER adjusts the NEER for price changes. So, REER shows international competitiveness.
• REER and NEER: The REER is a country's NEER after removing price inflation or labor cost inflation.   IMAGE
• RBI’s formula for REER: Base year is 2004-05, and six-currencies are of China, HK, US, Eurozone, Japan and UK. It is at 123 today, so INR (as per RBI) is 23% overvalued in comparison to larger economies. NEER was at 64 in July 2018!
• Change the base year: RBI NEER and REER for 2016-17 base year were at 96 and 98 resp. So that would mean that decline has made INR more competitive.
• Broader 36-currency REER: Base year is 2004-05. It is at 115, showing a 15% overvaluation (often quoted by all). IMAGE
• Problems with RBI’s REER: 

1. RBI uses both manufacturing and commodities trade to determine weights in the REER formula. Bad. Use only trade in mfg. to determine a currency’s competitiveness, not trade in commodities. 
2. REER formula does not make any adjustment for “third market competition” and uses mainly bilateral weights. Ex CEA had pointed out that the broader 36-currency REER was giving undue weightage to UAE at 11.4% due to oil imports 
3. The Euro has the highest weightage at 12.7, but exporters from eurozone don’t compete much with Indian exporters. 
4. Proper double-weighting to take into account third market competition would have made Vietnam, B’desh, China and the Philippines get much higher weightage in the REER (as our exports compete with them a lot in external markets).

• So is the INR over-valued? No, it is not. The RBI 36-country REER is wrongly structured. Weights assigned are improper. The BIS’s broad index is better.
• Lower rupee is not helping increase exports: That being the case, rather the reverse often happens. So, time for change.
• Summary : The debate on the right value of the INR is skewed in favour of exporters today, but the RBI’s REER itself needs some fundamental corrections.

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