Is the rupee undervalued or is it overvalued?3 min read . Updated: 08 Oct 2018, 09:37 AM IST
The Indian currency appears fairly valued if one looks at price levels on the one hand and average purchasing power parity income levels on the other
Mumbai: Is the rupee fairly valued? This question is easier to ask rather than answer even at the best of times — and particularly so when the Indian currency is being hammered in the foreign exchange market. However, it still deserves attention since the exchange rate is the price that determines our economic interaction with the rest of the world.
There are at least three different ways in which to look at the value of the rupee. The first is the nominal exchange rate against the US dollar. This is the number that dominates the news these days. It is simply the relative price of the two currencies, or how many rupees it takes to buy one dollar. The usual rule is that the country with higher inflation needs to let its currency go down. The intuitive logic is quite simple: The external value of a currency has to move in tandem with its internal value. There are other factors such as productivity growth that matter as well, but the inflation differential is a good starting point.
The rupee has moved down from 42.4 to a dollar on 5 October 2008 to 73.8 to a dollar 10 years later.
That is a decline of 2.8% a year on a compounded average growth rate (CAGR) basis. The inflation differential between India and the US over this period is higher at 4.2%, as Indian prices accelerated while the US battled with deflation after its financial crisis. Seen through the prism of inflation differentials alone, the rupee has not lost as much ground as its high inflation would have us expect. More should be expected.
A wider measure of the value of a currency such as the Indian rupee is its real effective exchange rate (REER). This is a measure of the value of a currency against the currencies of major trading partners, and adjusted for inflation. The REER is commonly used to measure trade competitiveness, so an increase in the REER implies that exports become more expensive while imports become cheaper.
There are several ways to measure the REER, which is why different agencies come up with different estimates. The most convenient one to use is the estimate of the Reserve Bank of India since the central bank has traditionally used its 36-country REER as a lodestone to understand whether the rupee is overvalued or undervalued. India has been battling an overvalued rupee in recent years, and the REER has corrected only after episodes of sharp rupee depreciation. Critics of the REER say it is only an analytical tool, since most of Indian trade is billed in dollars while corporate borrowing is also in terms of specific currencies.
The third way to look at the valuation of any currency is through its real exchange rate. Goods will usually sell at the same price across the world because of international trade. However, not everything can be traded across borders, especially services such as medical care or haircuts. They tend to be cheaper in emerging markets such as India, so a dollar goes a longer way in Mumbai than in New York. That is the basic intuition behind the famous Big Mac index, with hamburger prices being used to guess whether currencies are overvalued or undervalued.
The menu of prices can be extended beyond hamburgers. A comparison of all prices— traded and non-traded—is done through purchasing power parity (PPP) adjustments. The idea of PPP is well known. What is less known is that it can be used to assess whether a currency is out of alignment based on international price comparisons, using what is known as the Balassa-Samuelson effect on how price levels in any country depend on its average income level. Services are cheaper in poorer countries, and their prices rise as wages go up with development.
The analysis here is based on data from the 41 major developed and developing economies tracked every week by The Economist magazine. It shows that the Indian currency is fairly valued if one looks at price levels on the one hand and average PPP income levels on the other.
Of course, that fact offers no relief to Indian policy makers in their ongoing battle to maintain order in the foreign exchange market.
Niranjan Rajadhyaksha is research director and senior fellow at the Mumbai-based IDFC Institute.