BackDollar’s runaway rally and the rupee’s overvaluation
Rupee most overvalued since 2004 based on 36-country real effective exchange rate
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It’s been an eye-popping week in the global currency markets. The dollar, which has been on a tear since last year, got a second wind and surged to levels that no one thought we would see. Certainly not this soon.
The US Dollar Index, which measures the value of the dollar versus a basket of currencies, hit the psychologically important level of 100 on Thursday—a level last seen in 2003. Since the start of this year, the Dollar index has gained more than 10%, adding to the near 13% gain seen in 2014. It gets more dramatic. Of the 10% gain seen since the start of 2015, 4% has come in the last week alone. Anyone tracking the currency markets will tell you this is not normal for a market that typically moves in decimal points.
Much of the move has come because of the weakness in the euro, which has moved ever closer to parity with the dollar. Having lost 13% in value this year, the euro is now trading at about 1.05 against the dollar.
So what’s going on? For most of last year, the dollar rallied because the monetary policy stance in the US was diverging from the monetary policy stance in Europe and Japan. The money printing machines in the US were slowing down with quantitative easing being wound down; but in Europe and Japan, it was the reverse, and central banks were loosening policy like never before.
This divergence has become more stark in 2015, especially over the past week. On Friday last, the US released employment data for February, which showed that the economy was adding jobs at a faster-than-expected pace. The unemployment rate also fell to a six-and-a-half-year low of 5.5%. The data led to a belief in the market that the US Federal Reserve may start raising interest rates as early as June and a hint of that may come as part of the March meeting of the Fed. Until its last meeting, the Fed had maintained that it would be “patient" in normalizing the monetary policy. Traders now fear the word “patient" and the sentiment that goes with it will be removed from the Fed’s statement and its thinking.
Ironically, the fear of the Fed hit the markets at the exact same time as the European Central Bank’s quantitative easing programme, which kicked off this Monday, with an intention to buy nearly €60 billion in government and private sector debt each month until next September.
The result—the euro has plummeted and the dollar has surged.
Equally noteworthy, though not entirely surprising, is that the rupee has barely reacted to the 10% gain in the dollar. So far this year, the rupee has been more or less flat (actually up 0.7%). This is in contrast to the kind of reaction we have seen from other emerging market currencies, where comparable units such as the Malaysian ringgit (-5%), the Indonesia rupiah (-6%), the South African rand (-5.7%) and the Turkish lira (-10.5%) have depreciated far more. The rupee, along with the Philippine peso and the Thai bhat, are the best performing currencies so far this year.
While this may be testament to the relative strength of the Indian economy and foreign investor enthusiasm towards Indian investments, it worsens the problem of overvaluation of the Indian currency.
According to the Reserve Bank of India’s (RBI) March bulletin, the 36-country real effective exchange rate (REER) was at 112.70 in February, compared with 110.05 in the previous month and 101.97 in the same month last year. This is the highest level that the 36-country REER has hit since 2004, according to data available from Bloomberg. Data prior to 2004 was not available.
This suggests that the currency is at historically high overvalued levels, with an overvaluation of more than 10%. RBI typically likes to see the REER stay close to the 103 level, since India imports more than it exports and it makes sense to have a slightly overvalued currency. But even after that being taken into account, the rupee is still significantly overvalued. Over time, this will damage India’s export competitiveness.
No surprise then, that RBI has been buying dollars aggressively from the market to prevent this overvaluation from getting worse. In January alone it bought a net of $12 billion from the foreign exchange market—the highest monthly purchase since January 2008. A consequence of the RBI’s dollar purchases has been the increase in foreign exchange reserves, which are now at a record high level of $338 billion. One can argue that more is better when it comes to foreign exchange reserves, but as even the RBI governor has acknowledged, reserves come at a cost. The International Monetary Fund (IMF), which released its annual report on India on Wednesday, notes that India’s forex reserves now stand at 148% of the IMF’s reserve adequacy metric.
Therefore, any further build-up in reserves, which comes as a by-product of the RBI’s attempts to keep the rupee’s overvaluation in check, will probably have more costs than benefits attached.
Ira Dugal is assistant managing editor, Mint.
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