Mumbai: The Indian rupee’s 2.3% appreciation last week has added to its over-valuation in terms of real effective exchange rate (REER), which is already near its highest since 2011.
A high REER value suggests that the rupee should still weaken by a big margin for it to be competitive. A look at REER based on a basket of currencies of 36 trading partners of India, which the Reserve Bank of India (RBI) tracks closely, shows a 10.38% overvaluation of the rupee in February. At that time, the rupee was trading around 68.50 per US dollar in the market. Ever since, the currency has appreciated to 67.10. To have a neutral REER, the rupee must be trading around 74 per dollar in nominal terms.
However, the lowest that the rupee is expected to hit during calendar year 2016 is 71 per dollar, according to a Bloomberg survey of 35 active market participants. In fact, expectations of the rupee’s depreciation to 70 are not widespread. Only 10 out of 35 active participants in a Bloomberg survey predict the rupee to hit 70 per dollar in calendar year 2016.
The median estimate of a Bloomberg survey of 35 active forecasters for the dollar/rupee pair is 68.10 per dollar for the quarter ending June and a marginal change to 68.50 per dollar for the quarter ending September.
The currency’s biggest weekly gain of 2.3% last week didn’t elicit a strong intervention by the central bank, according to currency dealers. In contrast, RBI is said to have intervened aggressively when the currency was approaching its all-time low in February.
So why is RBI not worried?
Perhaps, the answer lies in governor Raghuram Rajan’s comment last week on REER. “If you look at the real effective exchange rate, it (rupee) is flat. In other words, we haven’t really depreciated in real terms against the global currencies. We have been very very flat over the last couple of years," said Rajan on 17 February at an event in Kochi.
Indeed, if one takes into account productivity measures, the rupee is not overvalued, according to HSBC. “However, we do not believe the INR is currently overvalued. After adjusting for India’s stronger productivity growth relative to many of its trading partners, we estimate that the INR REER remains close to its long-term average," said HSBC in a 2 March report.
The REER of RBI in its present form does not take into account productivity measures and this lacuna has been pointed out by Rajan as well.
Since the start of 2011, the rupee has depreciated 33% against the dollar, moving from a rate of ₹ 44.70 per US dollar at the end of December 2010 to ₹ 67.30 now. That works out to a compounded annual rate of about 8.35% a year. The rupee hit an all-time low of ₹ 68.85 per US dollar on 28 August 2013.
To be sure, analysts are still predicting the rupee to weaken for the sixth straight year and the current bout of appreciation is expected to be temporary. HSBC expects the RBI to “lean against the wind" and intervene in the market as it has in the past.
But will RBI follow its past pattern?