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The real challenge for the rupee is in finding the financing for $80 billion of the current account deficit. Photo: HT
The real challenge for the rupee is in finding the financing for $80 billion of the current account deficit. Photo: HT

The weak rupee re-examined

India's dependence on external flows leaves the question of whether the current levels place a firm ceiling on the dollar against the rupee open-ended

Last week when the US dollar reached an all-time high of 58.99, I was prepared to say that the dollar had overshot its fair value against the rupee and that it was time to sell the greenback. A client demurred. He said it was at best a short-term trading call and the rupee had not become fundamentally undervalued.

Before we decide if a currency has dropped below its fair value against another, we should have a notion of what the fair value is. In 1990, India had its balance of payment crisis and in 1991-92, it devalued the rupee twice. Hence, the government must have felt and the International Monetary Fund (IMF) concurred that the rupee was overvalued, getting into 1990s. I used the end-1991 dollar-rupee exchange rate of 25.8 as fairly valued and then proceeded to calculate the purchasing power parity (PPP) exchange rate between the two using inflation differentials in the subsequent years between the US and India. IMF data was used. It is interesting that the actual exchange rate and the PPP exchange rate closely track each other until 2008. In the last four years, with rampant inflation in India, the rupee has become overvalued against the dollar. The PPP exchange rate should be around 71.4 by end-2012. Overvaluation is even worse if we start from end-1993, when it ended the dual exchange rate.

However, if one examines The Economist Big Mac Index or IMF and World Bank estimates of India’s gross domestic product adjusted for PPP, the exchange rate should be around 20-22. In fact, according to the Big Mac Index, the rupee is the world’s most undervalued currency against the dollar. Hence, obviously, the rupee was grossly undervalued at 40 or 44 while it is somewhat more so at 57-58 to a dollar. Yet, the dollar has strengthened from 44 to 59 in the last one year. Therefore, we cannot rely on PPP fair value.

For economies that begin to catch up on the growth curve, real exchange rate appreciation is inevitable. That is what the theory says. India’s growth rate since 2003 has exceeded world growth rate on average and the US growth rate in particular. So, Indian currency has to gain in real terms not just against the US dollar but against all currencies. In other words, India’s real effective exchange rate (REER) must appreciate over time, as long as India maintains a higher growth rate than the rest of the world. Well, the present government has done its part to ensure REER appreciation. With reckless spending, it has ensured that India has a much higher inflation rate than others. That causes REER to appreciate. Yet, the Reserve Bank of India’s REER has dropped by about 5.5% up to May from the base year 2004-05. Hence, one can conclude that the nominal exchange rate of the rupee has weakened substantially or excessively against other currencies.

The real challenge for the rupee is in finding the financing for $80 billion of the current account deficit. This is the second largest trade gap in the world. Baseline assumptions on foreign direct investment, foreign portfolio investment inflows and worker remittances bring in only around $65 billion for 2013. Banking flows should bring in the rest comfortably in normal times. However, attitude towards emerging economies is turning cautious in the light of uncertainties surrounding quantitative easing in the US. Consequently, portfolio flows too are vulnerable to shifts in risk-taking attitudes on the part of investors.

Hence, the conclusion is that while the nominal rupee exchange rate is substantially undervalued, India’s dependence on external flows in the current environment leaves the question of whether the current levels place a firm ceiling on the dollar against the rupee open-ended. My client was right.

V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

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