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Home / Market / Mark-to-market /  A tale of three REERs and why we should leave the rupee alone

As rumours of an impending devaluation of the currency swept through the markets on Thursday, subsequently denied by the finance ministry, the question for debate was: should the central bank try to depreciate the rupee?

Perhaps a look at REER, or the real effective exchange rate, will help. REER is the weighted average of a country’s currency, relative to a basket of other currencies, adjusted for inflation. By this yardstick, the Indian rupee is at its Goldilocks level, is grossly overvalued or perhaps marginally overvalued all at the same time.

How is this possible?

The Reserve Bank of India’s (RBI’s) REER based on a trade weighted 36-currency basket makes the rupee look overvalued by 13% in August, while another REER index based on a six-currency basket makes it look overvalued by just 4.9%. REER of various countries arrived at by the Bank for International Settlements (BIS) puts the rupee at just its right level as of July. Much seems to depend on the base year selected. So, take your pick.

That said, macroeconomic theory suggests that the exchange rate of any country is expected to weaken to the extent its inflation differs with its trade partners. Retail inflation is expected to average around 5% this year and the rupee has weakened by just 1.24%.

Indeed, compared to its emerging market peers, the rupee has hardly budged. Its 1.24% drop since January looks stark when most other emerging market currencies have surged by at least 5%. Most analysts forecast the rupee to fall to 69-70 per US dollar by December.

But proponents of a sharp depreciation, including the anonymous government official on a television channel suggesting a devaluation, are ignoring two key points.

Firstly, the fall in exports has little to do with the exchange rate and more to do with depressed global trade.

Secondly, REER does not account for productivity. This is the reason even RBI does not seem to take REER seriously. In July this year, former RBI governor Raghuram Rajan pointed to this lacuna in REER and said that the rupee at that time was reasonably valued.

Any effective exchange rate measure of the rupee is bound to have limitations. Apart from that, there is high cost to unbridled intervention in the exchange rate market and RBI’s interventions over the last three years have increased manifold. Dragging the rupee down sharply will have implications for inflation which the central bank can least afford given its mandated target now.

In short, it’s best to leave the rupee to market forces. After all, a relatively stronger currency cannot look out of place when the balance of payments is in surplus.

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