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The rupee remains overvalued

Although there are many explanations for the rupee's recent slide against the dollar, none except those that look at it in a structural sense is fully convincing. Of the latter, issues relating to India's balance of payments or the changes contemplated in the country's exchange rate policy are considerably more relevant in explaining the rupee's recent fall. The rupee went down to Rs. 46 to a dollar on Tuesday, its lowest level since the end of September 2004. For a fairly long spell it had been appreciating in terms of the dollar and, to a lesser extent, in relation to the other major currencies — the euro, the yen and the pound. The high point of the rupee's strength was reached at the beginning of this year when it was quoted at Rs. 43.70 to the dollar. Recent dollar-rupee movements have occurred in phases, a sharp movement either way usually followed by a period of relative quiet. The present phase of decline that began in August gained momentum from early October. Obviously, there are important implications for the macro economy. The changing external value of the rupee and the time span over which it has fallen may not be striking enough to be sensational, but they do reflect the changing trends in the external sector. The rupee's fall in the immediate period is attributed, among other things, to the recent gains of the dollar in the global markets.

Despite its recent fall, the rupee continues to be overvalued in real terms. This will only get accentuated when the Reserve Bank of India implements its recent decision to expand and update its list of currencies that go into its indices for measuring the nominal effective exchange rates (NEER) and the real effective exchanges rates (REER). Two currencies from a very important trading zone, the Chinese yuan and the Hong Kong dollar, have been added and, with the euro replacing the franc and the mark, the number in the list has gone up to six. It is expected that India's trade competitiveness as measured by the rupee's external value will be more apparent once the new currencies are in place. Even more directly, the yawning merchandise trade deficit is a major worry and from the point of view of exports, there is a strong argument for a cheaper rupee. The trade deficit has increased from $15.4 billion during 2004-05 to $38.1 billion last year; it is $15.8 billion in the first quarter of this year, despite a strong export performance. The current account that remained positive for three consecutive years went into deficit last year. Both oil and non-oil imports have surged, with different implications for the macro economy. In aggregate terms, remittances and inflows which have bridged the current account deficit are not growing to the extent desired. Recent data from the stock markets suggest that the overwhelming dependence on capital flows for propping up the BOP might have now turned more risky, a point the RBI has been making for a long time.

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