India does not have a freely floating Rupee, which is to say, our exchange rate is determined heavily by the actions of the Reserve Bank of India (RBI), which is our Central Bank, and not solely by the market. We take a look at some of the concepts and recent concerns and share some material of interest.
Figure 1: Argentine Sovereign Default 2002
In the absense of central bank interventions, the exchange rate is determined by fundamental factors. However, almost every country, or perhaps all of them attempt to manage the exchange rates of their currencies, in different magnitudes, for various reasons. The wikipedia article on currency regimes explains just how wild it can get – not only are there numerous exchange rate regimes (fixed, peg, managed float, free float), there are various sophisticated ways to manipulate this rate. Central banks today have an array of weapons to influence the exchange rate.
However, in practice, there are severe limitations to this intervention. Additionally, currency manipulation can lead to disastrous consequences. Figure 1 shows the Argentinian Financial Crisis of 2002 (please read the linked article) which led to sovereign debt default. To put it simply, trying to artifically fix exchange rate above the one determined the market causes Forex reserves to be depleted pretty fast, leading to sovereign debt default and eventual catastrophic devaluation of currency. Notice the flat line depicting 1-for-1 exchange between Peso-Dollar until the crisis after which the Peso is devalued.
Exactly the opposite case is that of China, which keeps its currency artificially low by buying dollars. China seems to have no trouble at all.
In other words, and this is very interesting – keeping your exchange rate low can be long-term sustainable, while keeping it high is not. It is easy to understand why this happens: Exchange rate is determined by relative demand for your currency. If you want to keep your currency artificially high, you have to sell Forex reserves in order to artificially create shortage of your currency. Clearly unless you have an unlimited supply of foreign reserves, this is impossible to achieve.
On the other hand, China for instance, enabled by their strong economic growth can afford to keep buying foreign currency. This creates an artificial demand differential between the Renminbi and Dollar – causing the former to get a lower exchange rate than it would have otherwise got.
It is instructive to review the various financial crisis that have hit specifically the Asian and Latin American countries in the 80s and 90s. Since then, most countries have gotten smarter about not trying to monkey around with the exchange rate too much, specifically on the up side, not borrow too much in foreign currency denominated debt or rather not borrow too much, not print money etc. The current financial crisis mainly stems from structural reasons and not exchange rate interventions.
India’s Exchange Rate Regime:
Q: Finally, the rupee, it has been the underperformer in the Asian basket, at least in the past few months, that’s because of a broadening trade deficit. Any views on what the trajectory might be, is the bad days over or do you think that there is more appreciation for the rest of 2010?
A: We actually think structurally the rupee is a bit overvalued. If you look at it on a real exchange rate basis and you pointed to the trade deficit, we point to the large current account deficit currently being experienced by India, it suggests that the rupee is overvalued. So, in the longer term, we think that more depreciation is in stored for the rupee. (David Forrester, Vice President, Global FX Strategy, Barclays Cap, September 2010)
Some people tend to confuse forward looking analyst opinion with RBI intervention. When an analysts says for instance, the Re is overvalued, it does not mean RBI has artificially propped up the Re, merely the analyst thinks that based on the direction of fundamentals (GDP, trade balances, inflation etc.) the Re is likely to get devalued.
Sure enough, after this interview, the Re got devalued. From somewhere around 44 to now it stands at over 52, threatening to go down even further:
Figure 2: USD-INR Exchange Rate
Why is our exchange rate going South? Weakening fundamentals, lower than expected growth coupled with FDI drying up is causing this problem.
Now, let us hear from the RBI itself, the presumed villain:
Figure 3: History of Rupee Dollar exchange rate
There is a beautiful article on the RBI website, Exchange Rate Policy and Modelling in India which explains how India’s exchange rate regime changed over time. India claims to have introduced a market determined exchange rate in March ’93. In part, this reform came about after our financial crisis of 1990-91.
RBI’s own stated objective is as follows:
In this context, it is important to recognize that the Indian approach in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene if and when necessary, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way.
Since we can not take RBI at face value, we explore further.
Several Indian economists perform sophisticated research on the topic. Here is an extract from a paper
by well known economists Ila Patnaik, Ajay Shah et all – The exchange rate regime in Asia: From Crisis to Crisis May 2010):
The de jure exchange regime for the Indian rupee is that of a managed float since 1994. However, regression results for India suggest that there has been a cycle of inflexibility and greater flexibility, with very distinct breaks in the exchange rate regime. There was a long period of peg to the USD with an R2 of 0.84 till January 1994. The rupee value went back to a hard peg to the USD, taking the R2 of 1 till February 1995. Since then there has been greater flexibility in the rupee with both the beta coefficient on the USD and the Euro being significant.The rupee appears to have moved to a basket peg since April 2004 and on 23 March 2007, a further move towards flexibility came about. There are substantial differences between this history of the exchange rate regime, when compared with official statements and dates.
Yet another paper Is The Rupee Overvalued? (Feb, 2010) by Mathew Joseph and Karan Singh examines the Real vs. Nominal effective exchange rates:
In 2004-05, India’s current account was nearly in balance with a current account deficit of just 0.4 per cent of GDP. We can say that the rupee was in equilibrium that year. After touching a peak in 2007-08, the REER fell during the crisis period in 2008-09. However, it has been moving up again since March 2009. By November 2009, it had broken the equilibrium value and become overvalued to the extent of about 9 per cent. The REER computed using India’s WPI is a gross underestimate and wrongly gives the impression of an undervaluation of the rupee.
How do industrialists view our currency regime? They prefer the Re to be pegged to the dollar since it eliminates exchange rate risk. They also like an undervalued currency since it makes them more export competitive. Here is T.B. Kapali, Vice President (Economic Research) of Sriram Group in an op/ed:
A pegged rupee though seems an unrealistic expectation. Though there is a long history of the RBI actively managing the rupee (and also generally preferring a weak rupee), a de jure peg could be a different ball game for which the Government and the RBI may not be prepared. (We have said de jure here since the official policy of “managing the impossible trinity” goes some way in creating a de facto pegging regime in India).
A managed rupee exchange rate regime with a fair degree of volatile movements seems set to continue for the foreseeable future. In this world, we will see the RBI continuing to actively manage the rupee and slow down its structural appreciation — that is, allow only controlled appreciation.
To summarize: India has a de jure managed float exchange rate regime that has moved towards greater flexibility in recent years. To researchers, the regime appears to be de facto peg to the dollar since our largest trading partner is the US. However, India has moved to a basket of currency recently for its reference rate.
The exchange rate is managed within a narrow band but never deviating much from the market driven rate. The Re does get overvalued / undervalued for short time windows but but only by a small magnitude. There is a possible bias towards undervaluation. The main reason for managing the exchange rate by the RBI is to contain volatility which is caused by wild fluctuations in macro economic environment, wild swings in FDI – typical for a developing economy. Needless to say these things are under constant watch by academics, corporate houses, financial institutions and not the least – India’s trading partners.
Any abnormal manipulation is likely to be called out immediately. There are a few concerns about the exchange rate regime and lack of RBI transparency in their interventions, particularly moral hazard involving exchange rate guarantees and hedging facilities to corporates.
What is the ideal exchange rate?
The prevailing wisdom for developing countries is to keep the currency undervalued since it allows them to gain export competitiveness. China currently does it, Japan, Korea all have followed this regime. However, this is questionable.
Let us understand the implications of keeping the currency undervalued. Suppose you produce components for an export oriented firm. All your revenues come from domestic sources. The export oriented firm gets the major portion of revenues from abroad. The undervaluation will give you a lower revenue in local currency than you would have otherwise gotten. Now, if you have to import that machinery from Japan, you will spend more money than you should have. For the export oriented firm though, this is a great situation – they spend relatively less in costs at home, while getting more value for their dollar profits earned from aborad.
Ergo, an undervalued currency favors those who earn in dollars and spend in Re.
Clearly, the deliberate policy of undervaluation transfers wealth from one group of individual to another. The excuse given usually is, we create more export oriented jobs. Is that the reality for India? Are we really generating export oriented jobs? Our trade balances are deeply negative. We are nowhere near creating the kind of manufacturing jobs that say China is.
Additionally, an undervaluation eventually passes the cost to the poorest segment of the population. The net gainers are corporates and their rich employees. The poor pay with reduced standard of living.
In addition to this, undervalued currency causes structural long-term deficiencies in the economy that can be fatally harmful. Companies tend to try and export every which way they can of less value added goods. Their investment pattern shifts. While undervaluation makes one set of companies more viable (Revenue in $, COGS in Re), it makes another set unviable.
A completely market driven currency, aside from being long-term efficient is also the most moral solution.
References:
http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR1716R0412.pdf
http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15
http://macrofinance.nipfp.org.in/PDF/PS2007_sl_01_currency_regime.pdf
http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15
http://www.nipfp.org.in/working_paper/wp_2010_69.pdf
http://www.icrier.org/macro/12feb10.html
Big Mac:
http://www.thehindubusinessline.com/industry-and-economy/banking/article28082…
“Bit overvalued”
http://www.moneycontrol.com/news/rupee/rupee-looks-overvalued-says-barclays-c…
RBI says Rupee overvalued:
http://www.business-standard.com/india/news/re-overvalued-76-says-rbi/229257/&n
bsp;
“generally preferring a weak rupee”
http://www.thehindubusinessline.com/todays-paper/tp-opinion/article994362.ece…
http://eaces.liuc.it/18242979200901/182429792009060108.pdf
RBI speech:
http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=288
More recent RBI (from the horses own mouth)
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12252#CON
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12252#EXC
Argentinian currency crisis:
http://theinflationist.com/sovereign-default/argentine-sovereign-default-2002…
China:
http://money.cnn.com/2010/11/10/news/economy/what_is_currency_manipulation/in…