X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Who's afraid of rupee depreciation? - Outside View by S.S. TARAPORE
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Who's afraid of rupee depreciation?
Aug 21, 2015

Exchange rate management is shrouded in mystery. It conceals certain blunt truths, one of which is our overvalued currency

Exchange rate management is of intense interest to economists, financial analysts, forex market participants, industry and individuals. While analytical economists produce tomes on the theory of exchange rates and central bankers articulate their analytical prowess, to the general public exchange rate management is a mystical subject.

The secret of exchange rate management is best explained by an analogy to the sacred orders. When being initiated into the sacred order, the new entrant is required to take an oath of secrecy. The new entrant, after proper screening, is led into the sanctum sanctorum and then told that the sacred order has no secret!

From Bretton Woods in 1944 to 1971 the US dollar was pegged to gold and other currencies were linked to the US dollar. With the delinking of the dollar from gold there was a breakdown of the system as the reference point was lost and central banks were left to fend for themselves in the choppy oceans of international exchange markets.

Economists made their careers working out sophisticated models which were incomprehensible to practicing central bankers who could not be faulted for devising pragmatic approaches to exchange rate management. Some countries pegged to the US dollar while others pegged their currencies to an undisclosed basket of currencies, yet others used the Real Effective Exchange Rate (REER), i.e. a trade- weighted exchange rate adjusted for inflation rate differentials. Some major currencies vowed that they were following a 'clean' float, but invariably such floats had various shades of grey.

The Indian Approach

In the 1990s, the Reserve Bank of India (RBI) moved from an undisclosed basket to a REER based on two models with a base year, first a 5-country REER, and second a 36- country REER. In the first half of the1990s the operative Pole Star was the 5-country REER.

In the latter part of the 1990s the RBI gradually distanced itself from the REER. The RBI does continue to publish the two REER indices; however, there is no explicit commitment to using a REER. Having distanced itself from the REER, the RBI had to find a new deity which was labelled "Goddess Volatility” and the RBI claimed that it was committed to controlling excessive volatility.

In effect, what this boils down to is that there is no preset path for exchange rate movements but a pragmatic judgemental approach for RBI intervention in the forex market. The RBI party theoreticians would no doubt dismiss this as an inability of scribes to understand the philosophy of exchange rate management.

The harsh ground reality is that political economy imperatives mandate a strong rupee exchange rate. Needless to say, such a mandate is totally misplaced.

The exchange rate should reflect the macroeconomic strength of the Indian economy vis-a-vis the economies of major international currencies.

Dollar-rupee rate obsession

It is unfortunate that political economy considerations mandate that the rupee should not significantly depreciate against the US dollar. This becomes problematic when the US dollar appreciates vis-a-vis major currencies and gold.

It is necessary for the Indian polity to recognise that this is an unsustainable approach as an overvalued rupee adversely affects Indian exports and by making imports cheaper, kills Indian industry, particularly the micro, small and medium segments. Of course, the bulk of large industry is import intensive and benefits greatly from an overvalued rupee and this explains the political economy predilections for a strong rupee exchange rate.

Of course, there are erudite assertions that Indian productivity is higher than in the major industrial countries; this justifies a strong rupee. The Indian authorities would do well not to dwell too strongly on the productivity issue.

The REER (2004-05 as base) shows an appreciation of the rupee in June 2015 by 10 per cent on the 36-country index and 23 per cent on the six-country index. The REER is deemphasised on the ground that it does not cover the services sector and technically, the RBI has not been able to resolve this problem. Pending a perfection of the REER, the RBI should at least take cognisance of the fact that both the REER indices show overvaluation of the rupee.

Another way of looking at the appropriate nominal US dollar-rupee exchange rate based on the secular inflation rate differential between India and the US of 5.5 per cent, which, if followed, would require an appropriate nominal rate of US$1= Rs. 71.

Given the political economy predilection for a strong rupee, there would, understandably, be consternation at the mention of a rupee rate of Rs. 71 as being appropriate. Even the appreciation of the 36-country REER would warrant a depreciation to Rs. 71. There is merit in deftly depreciating the rupee from its present level. This would balance the contrary needs of exporters and importers.

Dealing with depreciation

One would not wish to underestimate the political economy imperatives. Within these constraints it should be possible to undertake corrective measures. A well known approach is 'boiling the frog'. Under this well known experimental psychology example of a frog sleeping in comfortable warm water getting boiled as the temperature is increased very gradually.

The recent international developments give a suitable opportunity to undertake a gradual depreciation. The recent Chinese depreciation provides one such opportunity.

The Chinese central bank explicitly states that the yuan is currently overvalued by 10 per cent. Policymakers in India must take note of the fact that no emerging market economy has prospered with an overvalued exchange rate.

The RBI would do well to restrain itself in supporting the rupee by forex sales. When there are heavy capital flows, the RBI should actively mop up the inflows by an admixture of spot and forward purchases.

The RBI should not be persuaded by vested interests warning about inflationary effects of a depreciation of the rupee. It is argued that with the recent RBI-Government Agreement on the Framework of Monetary Policy, the RBI should not countenance a depreciation of the rupee. Controlling inflation and an appropriate exchange rate are not antithetical to each other.

Please Note: This article was first published in The Hindu Business Line on August 21, 2015.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Equitymaster requests your view! Post a comment on "Who's afraid of rupee depreciation?". Click here!

1 Responses to "Who's afraid of rupee depreciation?"

Ralph Rau

Aug 21, 2015

Inflation has abated. With the collapse in Oil prices inflation should be running closer to zero than 5%

Oil prices are expected to stay at these subdued levels for the foreseeable future.

This should allow the Rupee to devalue by 10% without disturbing the RBI's 4-6% "target" (NB:target does not mean actual) rate

Like 
  
Equitymaster requests your view! Post a comment on "Who's afraid of rupee depreciation?". Click here!

More Views on News

What They Forgot to Tell You About Sensex at One Lakh (Smart Contrarian)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

Have You Submitted Your Tax Saving Investment Declarations? (Outside View)

Feb 17, 2018

PersonalFN explains the care to be taken while submitting tax saving investment declarations.

The Foundation for Sensex 100,000 is Laid (The 5 Minute Wrapup)

Feb 17, 2018

Top three reasons for Tanushree's presentation at Equitymaster Conference to be centered around a possible 30% correction.

Vignettes From Ireland (Vivek Kaul's Diary)

Feb 17, 2018

Bill bonner discusses how the US government have created a phony picture of the real condition of the country.

More Views on News

Most Popular

Here's What You Should Do in this Market Crash(The 5 Minute Wrapup)

Feb 6, 2018

The market correction has provided a golden opportunity to buy five high-quality safe stocks.

As the Market Corrects... It's Time to Buy More(Smart Contrarian)

Feb 5, 2018

The recent sell off in the stock market offers buying opportunity in some quality small caps.

The Era of Easy Money is Coming to an End. What Happens Now?(Vivek Kaul's Diary)

Feb 9, 2018

The easy money policy of the Federal Reserve of the United States, which drove up stock markets all over the world, is ending, with the Federal Reserve looking to shrink its balance sheet.

When Small is Not Always Beautiful(Chart Of The Day)

Feb 6, 2018

Big companies enjoying tax deductions and exemptions have an edge over the small companies.

What Should Mutual Fund Investors Do After LTCG Tax Norms(Outside View)

Feb 6, 2018

PersonalFN explain what investors should after LTCG tax norms.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Feb 16, 2018 (Close)

MARKET STATS