12/11/2018 Is the rupee overvalued or undervalued?

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Is the rupee overvalued or undervalued?

The only way to improve our understanding of currency valuation is to broaden existing
models and incorporate the nancial, social and political realities of our world and its
societies
Last Published: Wed, Jul 25 2018. 09 27 PM IST

Rohan Chinchwadkar

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Afew weeks back, the vice-chairman of NITI Aayog, Rajiv Kumar, told reporters that
the Indian rupee was overvalued by 5-7%. Since then, several experts have claimed
that the rupee is overvalued by around 15%. At the same time, other reports claim that
the rupee is actually undervalued by around 10%. Why is there such a stark difference
of opinion regarding the valuation of India’s currency? More importantly, is the rupee

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12/11/2018 Is the rupee overvalued or undervalued? - Livemint

undervalued or overvalued? To understand that, we need to delve deeper into a key

variable in international economics: the real effective exchange rate (REER).

What is REER? To put it simply, REER is an indicator of the competitiveness of a

country’s currency with respect to a basket of currencies, adjusted for inflation effects.
India’s REER is measured as a weighted average of India’s bilateral real exchange
rates with all the countries in the basket. Thus, REER has two components: (i) real
exchange rates and (ii) weights assigned to each currency.

The real exchange rate calculates the purchasing power of a currency by adjusting the
nominal exchange rate for inflation effects. If the dollar/rupee nominal rate is 69, it
means that you have to pay ₹69 to buy one dollar in the money market. However,
while nominal exchange rate focuses on the exchange of money, real exchange rate
focuses on the exchange of goods and services (US goods vs Indian goods). It measures
the number of units of a domestic good you have to pay to buy one unit of the
equivalent foreign good.

The second component, weights, depends on the importance of the countries in the
currency basket as India’s trading partners. For each foreign country, the weight
represents its share in the trade which India conducts with all the countries in the
basket. In April 2014, the Reserve Bank of India (RBI) released a circular which
mentioned that its 36-currency trade-weighted REER index assigns a weight of 8.8%
for the dollar.

Furthermore, REER is calculated in such a way that an increase in its value signifies
appreciation of the rupee. If we assume that the rupee was “fairly” priced in the base
year (when the index was set to 100, currently 2004-05), REER of more than 100
indicates that the rupee is overvalued. Since the current value of the trade-weighted
REER index is around 115, we see several experts claiming that the rupee is 15%
overvalued.

Before we accept this claim, we need to consider two biases in REER.

The first bias emerges from changes in relative productivity between India and other
countries in the basket. According to the Harrod-Balassa-Samuelson effect, a rise in
productivity in the tradable goods sector leads to an appreciation of REER (through
wage increases in the non-tradable sector).

However, since this REER appreciation is assumed to have no effect on trade

competitiveness (due to law of one price), it creates a bias in REER. The productivity-
adjusted REER is currently around 90, which implies that the rupee is undervalued by
10%.

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The second bias exists because REER ignores the hierarchical nature of the
international monetary system. It assigns weights to different currencies based on the
amount of bilateral trade between India and the respective countries, not based on the
share of each currency in India’s total trade payments. Given the dominance of the
dollar as the world’s reserve currency, a disproportionate share of global trade is
priced and settled in dollars, especially in commodities such as crude oil. In 2016, 80%
of India’s trade was settled in dollars, according to the inter-bank settlement system,
SWIFT.

However, the weight of the dollar in REER is only 8.8%. This under-weighting of the
dollar leads to a bias in REER, which the productivity-adjusted REER does not correct
for: overestimation of the aggregate strength of the rupee when it depreciates against
the dollar. A further adjustment for the hierarchy bias suggests that the rupee is
undervalued by more than 10%.

The hierarchy bias is particularly important right now since the rupee depreciation
against the dollar, combined with rising oil prices, has increased India’s import bill
(paid in dollars). But, despite the depreciation, export growth continues to be weak
because of rising protectionism, sluggishly recovering global growth and disruption of
domestic supply chains in the last two years. This view of trade and rupee valuation
supports recent actions of the Reserve Bank of India to arrest the depreciation of the
rupee against the dollar using foreign exchange reserves. Calls to let the rupee
depreciate further might need closer examination.

Valuation of currencies is still an inexact science, partly due to excessive narrowing

down of economic models which make unrealistic assumptions like the law of one
price and ignore international monetary hierarchy.

Alluding to the problem in a recent interview with the Institute for New Economic
Thinking, former RBI governor Raghuram Rajan said, “You shouldn’t narrow down so
much that you miss some of the bigger pieces that you’ve left out. Economies live in
society.” He encouraged economists to account for financial, social, and political
factors to get a better grasp of how economies actually work.

The only way to improve our understanding of currency valuation is to broaden

existing models and incorporate the financial, social and political realities of our world
and its societies.

Rohan Chinchwadkar is an assistant professor of finance at the Indian Institute of

Management, Tiruchirappalli.

Comments are welcome at views @livemint.com

First Published: Wed, Jul 25 2018. 09 11 PM IST

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