May 10, 1999
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KAUTILYA Price and Prejudice Exchange rate is ultimately a matter of price--not pride. By Jairam Ramesh Recently, the rupee was very much in the news until it was overtaken by political events. Reports of differences over the "appropriate" value of the rupee between the Finance Ministry and the Reserve Bank of India (RBI) had surfaced in the media. The finance secretary was supposed to be in favour of a weaker rupee to boost exports, while the RBI saw no need for any adjustment. Actually, the newspapers were unfair to the finance secretary. The sequence of events was roughly like this. Kautilya, while making a presentation on the industrial slowdown to the Confederation of Indian Industry, pointed out that India's great export boom of the mid-'90s was triggered in very large measure by the two devaluations of July 1991. He also pointed out that while our current round of export stagnation predates the collapse of the world economy in 1997-98, one of the factors that may have hampered the growth in our exports after 1996 is the 6 per cent appreciation of the rupee vis-à-vis the dollar between 1995-96 and 1997-98. To be fair, he added that in 1998-99 there has been a downward movement but this has had no appreciable impact on export performance. It is in response to this that the finance secretary said constant watch must be kept on our exchange rate so that exports do not suffer. It was an unexceptionable statement from the nation's top economic administrator. Coming on top of a statement in this year's Economic Survey that the rupee is overvalued, the newspapers flashed the news that the finance secretary is in favour of a depreciation. Figuring whether a currency is at its "correct" level is a tricky and complicated business. It is such an arcane topic that The Economist uses what it calls the Big Mac Index to enlighten its readers on the appropriateness of a country's exchange rate. It is based on purchasing power parity (PPP) -- the notion that an identical basket of goods and services should cost the same in all countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the US as abroad. Since the beef-filled Big Mac is not sold here, India is not included in this "burgernomics" exercise. A strictly-vegetarian Kautilya did some market research and found that the nearest to a Big Mac is the Maharaja Mac the selling price of which suggests that the rupee is undervalued against the dollar by a whopping 48 per cent, perhaps more a reflection of McDonald's marketing strategy and the structure of India's fast-food industry than of macroeconomic fundamentals. More seriously, staid central banks use a concept called "real effective exchange rate" (REER). The rupee's REER in relation to the dollar is the nominal exchange rate multiplied by the ratio of the Indian inflation rate to foreign inflation rates. It is REER that is relevant when assessing a country's international competitiveness. Every month, the RBI puts out two estimates, reer-5 and reer-36. reer-5 tracks the real effective exchange rate of the rupee in relation to a basket of the dollar, mark, pound, yen and franc. reer-36 tracks it in relation to a basket of 36 currencies, including those of India's main competitors. According to reer-5, with 1993-94 as the reference point the rupee is actually undervalued by about 2.4 per cent now. reer-36 uses 1985 as a base, which needs to be changed given what has happened to East Asian currencies in the past two years. The choice of the inflation measure is important. Indian wholesale and foreign consumer prices are used by the RBI. What appears an undervaluation using our wholesale prices becomes an overvaluation of 10 per cent using the consumer price index. The choice of the base year is equally important; 1993-94 is the normal choice since that is the year India switched over completely to a market-determined exchange rate. A little-acknowledged success story in recent years has been the smoothness of this transition, which took place with no flight of capital or no great volatility. It was the duo of Manmohan Singh and C. Rangarajan that was primarily responsible for this achievement. Rangarajan's view has always been that the containment of domestic price increases has the same beneficial effect as a depreciation of the nominal exchange rate. It is this view that informed exchange rate policy between 1995 and 1997 and has come under criticism. While there is no analytical formula and there is always balance to be struck between promoting exports and controlling inflation, the generally accepted principle of exchange rate management is the nominal exchange rate should "depreciate" by about the inflation differential. This means that we should not panic if the rupee adjusts by about 5 per cent or about Rs 2 every year in relation to the dollar. But in this country, even a 20 paise change is considered a wild fluctuation. If foreign investment inflows into the country this year remain at the previous year's level of around $2.4 billion -- or if they fall, as might well happen -- and if economic activity picks up then there will be a pressure on the rupee and we might see an automatic downward adjustment. But what is certainly not on is the use of foreign exchange reserves to drive down the rupee in order to kickstart exports. The author is secretary of the AICC's
Economic Affairs Department. |
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