The debate over a devaluation of the rupee for increasing exports has drawn attention to the behaviour of the exchange rate in recent months. The hypothesis of effecting a devaluation of the rupee for increasing the competitiveness of Indian exports assumes that the rupee has been strengthening against other major currencies or is valued more than what it should be. What does the exchange rate behaviour reveal in this regard?
Looked at on a monthly basis for the last three years, the exchange rate does reflect appreciation. The Nominal Effective Exchange Rate (NEER) of the rupee, computed by the RBI on trade-based weights for a basket of 36 countries, indicates an increase in the indices, pointing to an appreciation. However, the appreciation has been patchy and inconsistent. Beginning from August 2013, the NEER appreciated by more than 10% till March 2015. The appreciation kicked in from the early months of 2014 and can be explained by the pick-up in short-term capital inflows in anticipation of the electoral success of the NDA government. The robust pace of inflows was maintained till the early months of 2015. These inflows increased the supply of foreign currencies in the Indian economy relative to the rupee, leading to an increase in the value of the latter. Since the beginning of the last financial year, however, NEER’s appreciation has been arrested. From April 2015 to August 2016, the NEER index has reduced by around 3%. While the value of the index still remains around 6% higher than its level in August 2013, the last 15 months reflect fluctuations in the NEER, largely due to withdrawal of portfolio flows following the volatility in Chinese capital market and reallocation of capital by FIIs since middle of last year.
What is noticeable, however, is the greater appreciation in the Real Effective Exchange Rate (REER). Unlike the NEER, whose pace of appreciation slowed from April 2015 onward, the REER continued to appreciate till November 2015. Beginning from August 2013, till November 2015, the REER index increased by almost 15%. While it dipped for a few months, thereafter, it has begun increasing again since March 2016. During the last six months, while the NEER index has barely increased by only 0.05%, the REER has increased by almost 3%.
Increases in NEER can lead to similar increases in REER. But if the latter increases more than the former, then it is important to look beyond the NEER. The most plausible explanation for the REER increasing more than the NEER is that of domestic price levels in India being higher than those of countries part of the trade basket. The appreciation during the last few months can be attributed to increases in the CPI, which have significantly pushed up the REER, notwithstanding negligible increase in NEER. If the trend is maintained then further increases in REER cannot be ruled out. Moreover, the overall trend in REER for the last three years reflects a greater increase in NEER, which again points to the contribution of domestic prices, relative to other country prices.
Given the trends in NEER and REER, how effective would be a calculated devaluation of the rupee in increasing competitiveness of Indian exports? The devaluation would work opposite to increase in prices. Whether the REER would increase or decrease following the devaluation would depend on whether the decline in NEER would be more or less than the increase in domestic prices. But if inflation continues to increase, then the effect of a devaluation on the REER might be marginal, or even none. Furthermore, from a policy perspective, while the Central Bank might have a direct handle on influencing the exchange rate, it would not have similar influence over the CPI, certainly not relative to prices of other countries.
It has for long been established that devaluation, or for that matter even currency depreciation, tends to increase the competitiveness of those exports that are price-elastic in nature, and whose demand is influenced by small changes in prices. In a situation of overall low global demand for exports, there could be arguments in favour of price substitution. However, the effectiveness of the argument depends largely on the composition of India’s export basket. India’s major exports – petroleum products, pearls & semi-precious stones, gold, pharmaceuticals and readymade garments – are a mixed lot in this respect. The price-sensitivity of their demand would vary according to markets and consumer segments.
The key challenge for addressing competitiveness of Indian exports remains domestic prices. These, if stubborn, would force the REER to appreciate, notwithstanding devaluation. The challenge is further increased at a point in time when India is introducing the GST. A relatively high GST rate might be inflation-inducing. Such a situation would entail further pressure on the REER making it appreciate and eroding competitiveness of exports.
The author is senior research fellow and research lead (trade and economic policy) at the Institute of South Asian Studies (ISAS), National University of Singapore. E-mail: [email protected], Twitter: @Amitendu1. Views are personal