Should the Government Devalue Rupee?

Mon, 19 Sep Pre-Open

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The commerce ministry is concerned over the continuous slowdown in exports. Contracting for the second month in a row, India's merchandise exports fell 0.3% to USD 23.5 billion in August on persistent weak demand in developed markets and subdued prices.

In a draft Cabinet note circulated earlier to seek views of different ministries, it has suggested that a mechanism be formulated to ensure the rupee-dollar exchange rate reflect the realistic value of the domestic currency. The ministry has argued that adjustments in exchange rate policy are needed as it is important to increase the competitiveness of the products.

Currently, Indian currency's real effective exchange rate (REER) is viewed as overvalued compared to several countries like Mexico, South Africa, Argentina and Brazil. The REER is the weighted average of a country's currency relative to an index or basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index. By this yardstick, the Indian rupee is overvalued.

Macroeconomic theory suggests that the exchange rate of any country is expected to weaken to the extent its inflation differs with its trade partners. Retail inflation is expected to average around 5% this year and the rupee has weakened by just 1.24%.

In this case, should the rupee be devalued? It is important to understand what devaluation means. Devaluation is a policy of reducing the currency value against foreign currencies. It is a one-time large outsized policy driven move. Devaluation of currency essentially means, attempt to make Indian goods more attractive to foreigners as they would become cheaper. This will boost export competitiveness. Whereas, currency depreciation essentially means a change in the value because of market forces. That is, these countries allow supply and demand to determine the value of their currency relative to the currencies of other countries.

Given the rather global slump that we have, as far as trade dynamics are concerned, it is unclear how much of a devaluation is really going to help. Devaluation is a short-sighted strategy. The greater, long-lasting focus should be on enhancing productivity gains which, automatically, will feed through into export volumes and will help the exchange rate as well. The exchange rate should be thought as a stabilizer or as a shock absorber, rather than becoming a target point as far as policy is concerned.

To conclude, it is important to understand that the fall in exports has little to do with the exchange rate and more to do with depressed global trade. It's best to leave the rupee to market forces. After all, a relatively stronger currency cannot look out of place when the balance of payments is in surplus.

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