The Indian rupee touched a 14-month low last week. Most analysts expect it to continue to depreciate in the near term despite words from the DEA that at current levels, the INR USD seems to be at “fair value”.
There are multiple reasons for the fall in the rupee. For instance, the condition in the international financial market is tightening with yields on 10-year US government bonds touching 3% which could create issues in global fund flows , especially ones that thrive on interest rate levels or arbitrage. This is one of the reasons foreign investors sold Indian stocks and bonds worth about $2 billion in April. Further, global crude oil prices have gone up by over 10% since the beginning of the year and are expected to remain elevated in the foreseeable future. Crude prices have gone up by over 40% over the last one year and are putting pressure on India’s current account deficit, which is expected to have expanded from about $15 billion in FY17 to about $50 billion in FY18. Higher crude prices are also affecting bond prices, which in any case were under pressure due to the higher expected supply of government bonds.
What has also spooked markets is the U.S. Treasury’s semi-annual report on April 13 which added the Indian currency to the ‘watch list’ of nations that may be intervening excessively in their foreign exchange markets and distorting trade flows.
India was added to the list because it meets two of the three criteria laid down by the U.S. Treasury. It uses three benchmarks:
- A bilateral trade surplus with the U.S. of more than $20 billion. India’s bilateral trade surplus (merchandise and services) with the U.S. stood at $28 billion in 2017, according to the U.S. Treasury report. The surplus is actually marginally lower than the $30.8 billion recorded in 2016, shows data available on the website of the U.S. Trade Representative.
- A current account surplus of at least 3 percent of GDP.
- Net purchases of foreign currency of 2 percent of GDP over a 12-month period.
India, the report found, meets the first and third criteria.
The Indian currency is also not seen as undervalued by the International Monetary Fund and U.S. Treasury’s report acknowledged as much. The 36-country Real Effective Exchange Rate index compiled by the Reserve Bank of India was at 117 as of March 2018, suggesting, if anything, that the Indian currency is marginally overvalued.
The RBI’s most recent annual report assessed the rupee to be “closely aligned to its fair value over the long term”. According to latest RBI data, released last Friday, India’s forex reserves rose by $503.6 million to touch a record high of $424.86 billion in the week ended April 6, 2018. Of this, foreign currency reserves were $399.776 billion. Direct intervention has supported a steady increase in foreign exchange reserve levels. At the end of 2013, foreign currency reserves were $268 billion, or 2.3 times short-term external debt, 6 months of import cover, and 14% of the GDP.
How is Fair Value of a currency determined?
The indices of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) are used as indicators of external competitiveness.
The nominal exchange rate represents the current value of a currency against another country’s currency. The exchange rates that we see on display in banks or at airport exchange kiosk are Nominal effective exchange rate.
NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies while the REER is defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries, relating to the purchasing power parity (PPP) hypothesis.
The real effective exchange rate (REER) is used to measure the value of a specific currency in relation to an average group of major currencies. The REER takes into account any changes in relative prices and shows what can actually be purchased with a currency. This means that the REER is normally trade-weighted.
A country’s REER can also be derived by taking the average of the bilateral real exchange rates (RER) between itself and its trading partners and then weighing it using the trade allocation of each partner. Regardless of the way in which REER is calculated, it is an average and considered in equilibrium when it is overvalued in relation to one trading partner and undervalued in relation to a second partner.
Benefits of Analyzing and Using the REER
The REER can be used to measure the equilibrium value of a country’s currency, identify the underlying factors of a country’s trade flow, look at any changes in international price or cost competition and allocate incentives between tradable and nontradable sectors.
Understanding a country’s REER is extremely important when conducting economic analysis and policymaking. Therefore, the World Bank, RBI, the Eurostat, the Bank for International Settlements (BIS) and others all publish various REER indicators.