Ru­pee ap­pears fairly val­ued if one looks at price lev­els on one hand and aver­age pur­chas­ing power par­ity in­come lev­els on the other


Is the ru­pee fairly val­ued? This ques­tion is eas­ier to ask rather than an­swer even at the best of times , par­tic­u­larly so when the cur­rency is be­ing ham­mered in the for­eign ex­change mar­ket. How­ever, it still de­serves at­ten­tion since the ex­change rate is the price that de­ter­mines our eco­nomic in­ter­ac­tion with the rest of the world.

There are at least three dif­fer­ent ways in which to look at the value of the ru­pee. The first is the nom­i­nal ex­change rate against the US dol­lar. It is sim­ply the rel­a­tive price of the two cur­ren­cies, or how many ru­pees it takes to buy one dol­lar. The usual rule is that the coun­try with higher in­fla­tion needs to let its cur­rency go down. The in­tu­itive logic is quite sim­ple: The ex­ter­nal value of a cur­rency has to move in tan­dem with its in­ter­nal value. There are other fac­tors such as pro­duc­tiv­ity growth that mat­ter as well, but the in­fla­tion dif­fer­en­tial is a good start­ing point.

The ru­pee has moved down from 42.4 to a dol­lar on 5 Oc­to­ber 2008 to 73.8 to a dol­lar 10 years later ( chart 1). That is a de­cline of 2.8% a year on a com­pounded aver­age growth rate (CAGR) ba­sis. The in­fla­tion dif­fer­en­tial be­tween In­dia and the US over this pe­riod is higher at 4.2%, as In­dian prices ac­cel­er­ated while the US bat­tled with de­fla­tion af­ter its fi­nan­cial cri­sis. Seen through the prism of in­fla­tion dif­fer­en­tials alone, the ru­pee has not lost as much ground as its high in­fla­tion would have us ex­pect. More should be ex­pected.

A wider mea­sure of the value of a cur­rency such as the In­dian ru­pee is its real ef­fec­tive ex­change rate (REER). This is a mea­sure of the value of a cur­rency against the cur­ren­cies of ma­jor trad­ing part­ners, and ad­justed for in­fla­tion.

The REER is com­monly used to mea­sure trade com­pet­i­tive­ness, so an in­crease in the REER im­plies that ex­ports be­come more ex­pen­sive while im­ports be­come cheaper.

There are sev­eral ways to mea­sure the REER, which is why dif­fer­ent agen­cies come up with dif­fer­ent es­ti­mates. The most con­ve­nient one to use is the es­ti­mate of the Re­serve Bank of In­dia since the cen­tral bank has tra­di­tion­ally used its 36-coun­try REER as a lode­stone to un­der­stand whether the ru­pee is over­val­ued or un­der­val­ued. In­dia has been bat­tling an over­val­ued ru­pee in re­cent years ( chart 2), and the REER has cor­rected only af­ter episodes of sharp ru­pee de­pre­ci­a­tion. Crit­ics of the REER say it is only an an­a­lyt­i­cal tool, since most of In­dian trade is billed in dol­lars while cor­po­rate bor­row­ing is also in terms of spe­cific cur­ren­cies.

The third way to look at the val­u­a­tion of any cur­rency is through its real ex­change rate. Goods will usu­ally sell at the same price across the world be­cause of in­ter­na­tional trade. How­ever, not every­thing can be traded across borders, es­pe­cially ser­vices such as med­i­cal care.

What the Balassa Sa­muel­son ef­fect tells us

Ra­tio of do­mes­tic to US prices in log terms 0 They tend to be cheaper in emerg­ing mar­kets, such as In­dia, so a dol­lar goes a longer way in Mum­bai than in New York. That is the ba­sic in­tu­ition be­hind the fa­mous Big Mac in­dex, with ham­burger prices be­ing used to guess whether cur­ren­cies are over­val­ued or un­der­val­ued.

The menu of prices can be ex­tended be­yond ham­burg­ers. A com­par­i­son of all prices—traded and non-traded—is done through pur­chas­ing power par­ity (PPP) ad­just­ments. The idea of PPP is well known. What is less known is that it can be used to as­sess whether a cur­rency is out of align­ment based on in­ter­na­tional price com­par­isons, us­ing what is known as the Balassa-sa­muel­son ef­fect on how price lev­els in any coun­try de­pend on its aver­age in­come level. Ser­vices are cheaper in poorer coun­tries, and their prices rise as wages go up with de­vel­op­ment ( chart 3).

The anal­y­sis here is based on data from 41 ma­jor de­vel­oped and de­vel­op­ing economies tracked ev­ery week by The Economist. It shows that the ru­pee is fairly val­ued if one looks at price lev­els on the one hand and aver­age PPP in­come lev­els on the other.

Of course, that fact of­fers no re­lief to In­dian pol­icy mak­ers in their ongoing bat­tle to main­tain or­der in the for­eign ex­change mar­ket.

Ni­ran­jan Ra­jad­hyak­sha is re­search direc­tor and se­nior fel­low at IDFC In­sti­tute, Mum­bai.

₹ has moved down from 42.4 to a dol­lar on 5 Oc­to­ber 2008 to 73.8 to a dol­lar 10 years later

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