Starting with equilibrium values of a currency in the medium and long term, for long the purchasing-power parity method has been used by economists to estimate the "true" value of the currency. Increasingly however, an alternate method of calculating the correct value of a currency is being used. Known as the Fundamental Equilibrium Exchange Rate (FEER), this new measure tries to factor in the effect of capital flows on the currency's value. Since capital flows have long since overtaken trade flows in magnitude, and indeed amount to 70 times the size of trade flows, the FEER is now regarded a better method of finding the proper price of a currency.

The FEER recognises that if a country is to run a current account deficit over a long period, it will need to run a trade surplus to repay its obligations. This is possible only if the currency's exchange rate is persistently below its purchasing power parity rate. Thus the FEER of a currency is this value that is consistent with the country's likely current account balances over the long term. As the country's need and ability to finance a current account deficit change, the fundamental equilibrium rate of the currency also changes. Given our economic outlook over the medium term, we should expect the rupee's value to keep declining.

To see why, consider this fundamental identity in macroeconomic accounts. Domestic spending in any economy is the sum of spending on consumption and investment and government spending. In a closed economy, total domestic spending should be equal to total national income. Once the economy is allowed to borrow from external sources, the economy spends more than it earns. In other words, the current account balance is only a reflection of the gap between the amount invested and the amount saved in the economy. The point here is that external deficits are caused primarily by the excess of spending over income. Given the Government's role in the country's economy, this means that external deficits in our country are primarily caused by Government deficits.

This need not necessarily be a bad thing. Indeed, in a developing economy, as long as the borrowings are used to invest in productive capacity, a current account deficit may be a necessity.

This is where the troubles start. India's fiscal deficit averages over 6 per cent of the GDP. Given the political economy of spending on subsidies and the like, there is really no reason to expect that this deficit can be brought down easily. If public sector and state government finances are taken into account, the public-sector deficit is expected to touch nearly 10 per cent of the GDP.

This sum represents the public-sector dissavings in the economy. What this has meant is that even as the Government undertakes measures to increase the private savings rate in the economy, its profligacy undermines the public savings rate. This has increased the size of the investment - savings gap, thereby increasing the need to run a current account deficit.

What is disquieting about this is the fact that 60 per cent of this deficit is gobbled up by the revenue deficit. This means that more than 4 per cent of the GDP is spent to finance unproductive Government consumption. And worryingly, the capital's share in the spending programme of the Government has steadily decreased over time.

This is disturbing because by cutting down capital spending, we reduce our future productivity and, therefore, our ability to repay debts. Further, as our debts increase, we have to run ever larger trade surpluses to repay debts. If productivity does not rise, the country will have to rely on a low-cost strategy to increase exports. This means that the rupee will have to be even more undervalued relative to its purchasing power parity value. The outcome will be a lower rupee.

There are other reasons to believe the gap between investment and savings might increase in the future. Recent newspaper reports suggest that the marginal propensity to consume in the Indian economy has increased by around 20 per cent. This means that out of every additional income of rupee earned, the average Indian is inclined to spend around 84 paise on consumption, compared to 70 paise in 1988. The corollary to this is that, this same Indian is willing to save less of his income. In other words, the marginal propensity to save diminishes. This will have an effect on the investment savings gap by decreasing the total savings in the economy. Obviously, the need to borrow and, therefore, to run a current account deficit increases.

If India were to run a smaller revenue deficit, the gap between our investment needs and our savings would reduce, decreasing the need for a current account deficit. Another effect would be that as the Government reduces its consumption, it would drive down the demand for imports, and thus increase the trade surplus. As a result, the rupee does not have to be quite as undervalued relative to its longer term purchasing power value.

There are obvious lessons here for the conduct of policy. For one, changes in the exchange rate can affect the current account deficit only in the short term. This balance is more fundamentally affected by the savings-investment imbalance in the economy. Fiddling around with the nominal exchange rates without first correcting fiscal disequilibrium will only lead to an unsustainable external balance and inflation over time.