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Is the rupee undervalued?

Ila Patnaik

Last week, with his decision to allow residents to open foreign accounts, the RBI Governor, Bimal Jalan gave a clear signal of his view of the rupee. He is clearly comfortable with the strength of the rupee and the level of the reserves.

Since the Resident Foreign Currency Accounts will pay no interest, the returns on them in rupee terms can be measured by the depreciation of the rupee. If there had been signs of pressure on the rupee to depreciate, such a measure could have resulted in clever and ingenious ways to convert rupees to dollars.

It could have lowered RBI's forex reserves and reduced its artillery for defending the rupee when the time came. Only if such an event is not expected, the decision to allow foreign exchange accounts for residents is sensible.

Considering how cautious Jalan has always been, one can be certain that he must be very sure that there are no signs of a depreciation. If anything, he must be of the view that the rupee is already too strong and that it has become necessary to reduce the pressure on the rupee to become stronger by means other than just the RBI's purchase of foreign exchange.

The correctness of this view can be assessed by a simple test that involves revisiting some familiar macroeconomic identities.

India's current account deficit which recorded an average of 1 per cent over the last ten years, recorded a surplus in 2001-02. In 2002-03 the RBI expects the current account deficit to be below 1 per cent of GDP.

A simple analysis of the savings investment identity in an open economy indicates that at the level of the economy the current account deficit equals the inflow of capital into India. This, in turn, is equal to the excess of domestic investment over domestic savings.

The development strategy envisaged for India in the 1990s was to have an investment rate higher than the rate of domestic saving by attracting capital inflows. Estimates of sustainable capital inflows, levels that India could absorb without running into trouble, were sometimes put at about 2 to 2.5 per cent of GDP.

For this to be possible, India was expected to run current account deficits equal to this so that the inflow on the capital account could offset the deficit on the current account to achieve overall balance of payment equilibrium.

It was believed that an inflow on the capital account greater than the deficit on the current account would, to some extent, be desirable as it would help India build up foreign exchange reserves.

But, that was then. Today, if we agree that the foreign exchange reserve situation does not warrant any more additions to the reserves, the deficit on the current account must match the surplus on the capital account.

For the rate of gross domestic capital formation to exceed the rate of gross domestic savings, the country must run current account deficits. The amount by which we want domestic investment to be higher than domestic savings should be the current account deficit.

By this logic, India should be consistently running current account deficits. And, if instead of running deficits of about 2 per cent of GDP it runs current account surpluses, it suggests that the exchange rate is undervalued.

Certainly, when the current account deficit is higher than desired levels, the blame is put on the exchange rate. That is to say, if the situation had been the converse, i.e., if the country was running large deficits, it is likely that there would have been a general consensus that the rupee was overvalued which was why the current account deficit was too large.

After all, the ultimate test of whether a currency is correctly valued or not lies in the outcome of the current account balance. But when the current account is seen to have a surplus, there is very little consensus that the rupee is undervalued.

One reason for this seemingly contrary behaviour is that surpluses, per se, are not seen as bad. They do not create any visible crisis. Whether this is due to traces of merchantilism, or is the aftermath of the 1991 crisis, policy makers tend to see deficits as bad and surpluses as good.

As a result, what is being ignored is the somewhat disconcerting fact that India is unable to absorb the savings that are available with it and is in danger of becoming an exporter of capital.

In fact, this trend has been visible for about two years now. After 2002, India witnessed an increase in foreign exchange reserves that were not really the result of a conscious policy of the RBI.

Reserves were building up because of the surpluses on the balance of payments and the RBI's reluctance to let the rupee appreciate. This was in a way to be expected. It was natural because there has been, for long, an emphasis on the export led growth strategy.

An incorrectly valued exchange rate has too often been interpreted as an overvalued exchange rate, especially in the context of a developing country. On the other hand, the growth impact of an undervalued currency that limits the economy's capacity to import is a far less researched field in the context of trade and development.

The way the real exchange rate of the rupee is measured also often hampers rather than helps in assessing the over or undervaluation of the rupee. The way the exchange rate is measured by the RBI has been to estimate the Real Effective Exchange Rate that takes into account nominal exchange rates and inflation rates of trading partners.

There are issues of weights, base period, trading partners and competitors that figure in the discussion on trends in the real exchange rate, but in general, it is found that the REER does not indicate any serious appreciation of the Indian Rupee.

However, the weights include currencies of trading partners in India's merchandise trade. Since services now constitute over 30 per cent of India's exports, it is possible that if the measure took this into account the REER would behave differently.

While India's merchandise exports grew by nearly 2.5 times over the decade of the 1990s, the exports of commercial services quadrupled. It is, for this reason, time to re-examine the traditional concepts of merchandise as tradables and of measuring real exchange rates vis-à-vis merchandise.

As India's productivity in the tradables sector, that now includes services, increases, there would be a tendency for the rupee to appreciate.

If the RBI expects this sector to do well, as it has in the last decade, it would expect the pressure on the rupee to become even stronger. It's decision to allow residents to hold foreign currency accounts then makes perfect sense.

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