After a somewhat rocky February, the rupee has been back on an appreciation track through March. This has revived fears of currency overvaluation and erosion of export competitiveness. The real effective exchange rate index of the rupee against a six-currency basket computed by the investment bank JP Morgan (RBI’s own index is available only with a lag) currently shows a level of about 112. It was incidentally about 107 in January. This means that the value of the rupee adjusted for inflation differences between India and these six countries is up by 12 per cent over the base year, 2003-04, and up by roughly 5 percentage points over January. So the rupee is indeed overvalued. Besides, the fact that the rupee traded at a little over 39 at the end of 2007, depreciated all the way to around 52 in March 2009 and has now dropped below 45 suggests that RBI is following a hands-off policy towards the currency. The change in foreign exchange reserves is a broad measure of how much RBI has intervened to manage the currency. An effort to prevent appreciation by buying dollars manifests in an increase in reserves. The Indian central bank’s reserves dropped 6.5 billion dollars between December 2009 and March 2010. Some of this large decline could be explained by valuation losses since reserves are held in multiple currencies. It appears RBI was back in the market this week buying dollars.
Is RBI doing the right thing? As with all other economic policies, opinion is divided. However, those who believe that currency management is “distortionary” and leads to misallocation of resources are perhaps in a minority these days. If RBI ensures a competitive exchange rate through intervention it would, at worst, divert resources to the export sector. For an economy that has been excessively dependent on domestic demand for growth, that’s perhaps desirable. One could argue that while internal markets could ensure growth of around 8-8.5 per cent, the ability to reach the coveted double-digit rate would need a lot of support from external markets. Having an overvalued currency certainly does not help in achieving this. There is enough cross-country evidence to show that overvaluation hurts exports and overall growth. Studies show that a percentage point overvaluation, for instance, (measured by the real effective exchange rate) reduces long-term growth by roughly 0.1 per cent. There are translation losses associated with currency appreciation — every tick of appreciation is a straight hit to the bottom line as each dollar fetches fewer rupees. The loss of competitiveness is a bigger issue — appreciation means that Indian export prices are dearer in dollar terms. This is already happening. India’s problem is compounded by the presence of a behemoth neighbour, China, which happens to be a key competitor and its biggest trading partner apart from having a fixed exchange rate vis-à-vis the dollar. Even if China were to revalue its currency a tad in deference to the US’ wishes, it would continue to manage it closely within a band. Having a relatively flexible rupee when China manages its currency aggressively would hardly help our export effort. It would also open the floodgates to cheap imports. That said, managing a currency has associated costs. If RBI were to buy dollars, it would infuse rupees into the system and this liquidity could stoke inflation. However, these problems are relatively minor if managing the currency is seen as a long-term strategic imperative and can be handled with short-term monetary policy instruments like the cash reserve ratio. Finally, with the global crisis, yesterday’s heresies are today’s orthodoxy. For one, the stigma attached to capital controls has been washed away. Were the rupee to retain its momentum, RBI should not balk at considering curbs on external inflows.
