The Hindu : Business : A holistic view of exchange rates

Online edition of India's National Newspaper
Monday, Feb 14, 2005

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Business

A holistic view of exchange rates

Not the compulsions of export promotion alone but a combination of macroeconomic parameters may favour a cheaper rupee over the medium term.

IN CONTRAST to the frenetic stock market, the foreign exchange market has been relatively quiet recently. The rupee, after appreciating sharply against the dollar from August 2004 onwards (to touch a five-year high of 43.40 to a dollar) is now trading in a narrow range below the 44 level, reflecting global currency trends.

Currency movements on a day-to-day basis do not interest the public at large but the trends, even short-term ones, do. (In the latter case, public interest need not necessarily arise out of a desire to make or lose money or hedging the currency risks: the rupee's strength or weakness is often mistakenly correlated with the nation's economic strength).

Forecasting currency movements is an imperfect art even if its practitioners have enormous expertise and have access to the latest tools and reliable data. That is why predicting currency trends rather than movements is not only easier but also more meaningful to the layman.

The big question now is where will the rupee be in relation to the dollar, say, a year from now? One of course has to understand the basic ingredients of the exchange rate policy, which, since the early 1990s, has sought to leave the day-to-day movements in the forex market to be market determined.

Recently the Reserve Bank of India has once again spelt out the broad objectives of the exchange rate policy and management: to ensure that the external value of the rupee is realistic and credible; reduce excess volatility, prevent the emergence of destabilising speculation and develop an orderly forex market.

However, the forex market in India is not yet deep and is characterised by an uneven flow of demand and supply. There are a few large players who have come to exercise a disproportionate influence over currency movements. On the demand side two factors can cause a bunching up of requirements of foreign currencies: one, the oil sector's needs (to pay for imports) and two, the servicing of public debt.

Evidently, the limitations of the market mechanism ought to be recognised while forecasting exchange rate trends. But that is not all.

There is plenty of literature on the subject although, barring broad details, the exchange rate mechanism as practised here is still an arcane subject. All forecasters look at the following: High up is the five countries' Real Effective Exchange Rate Index (REER), an important benchmark for tracking the rupee's external value. (The five countries are the U.S., Japan, France, Germany and Britain. It adjusts for inflation and bilateral currency movements and has been around for a decade. The REER is used to explain the home currency's recent rise against the dollar thus: the rupee has appreciated against a weak dollar but it is not overvalued if seen against the REER. Hence a further appreciation of the rupee is still possible.

There are two types of shortcomings in an approach based entirely on the REER. First, the benchmark's utility as a measure of external competitiveness is questionable. India's trade with many countries (besides the five used in REER estimations) has been growing. If a wider index is put in place covering countries such as China, the rupee's external value can more realitstically gauged.

According to estimates, such a broad index will show the rupee to be overvalued, making a case for a policy induced weakening.

Second, there is a growing realisation that the exchange rate policy is part of the much larger monetary policy and hence subservient to certain broad macro economic goals.

Hence, it is necessary to look more closely at critical indicators such as inflation and trade balance to understand, leave alone predict the rupee's movements.

The decline in wholesale price inflation has been gradual since its peak level of 8.7 per cent in August 2004. If the prognosis for a benign environment comes true the RBI, far from tightening monetary stance, may actually loosen the purse strings by reversing the repo increase and CRR hike, both undertaken in late 2004.

Imports, already on the ascendant, may grow aggressively. A strong rupee is beneficial to importers (but detrimental to exporters). The view is that given the inelastic nature of oil imports and the fact that non-oil imports are also growing, the RBI may like to halt the rupee's continuous appreciation.

Such an outcome becomes even more plausible when one looks at the latest trade figures. During the second quarter of the year, the current account slipped sharply and went into deficit. (During the second quarter the deficit was $6.4 billion whereas in the first quarter the current account was in surplus by $3.2 billion). Merchandise trade deficit has widened and more ominously there has been a fall in invisible earnings (primarily remittances from overseas Indians).

Here is an opportunity to fine tune exchange rate policy, say some experts. That will involve working towards a weaker rupee. For, it may not be possible to service the current account through remittances and other invisible earnings alone. Exports will get a fillip through a less strong rupee. Not to be forgotten is the fact that the rupee's recent strength has been caused by an overabundant supply of dollars that have flowed to the capital markets through foreign institutional investors. There is a debate already over the "permanence'' of these flows which single handedly have driven the rupee to five-year highs against the dollar.

All these factors — a more benign price situation, widening current account deficit and the uncertainty over the FII flows — suggest a pronounced tilt in the exchange rate policy stance in favour of a cheaper rupee. The only hurdle to that course will be a revaluation of their currencies by China and other major Asian countries.

C. R. L. Narasimhan

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