The other side of the coin : Indian Rupee


How has the rupee faired in the last few months, we have read tons of content regarding the performance of the Rupee and other currencies versus dollars. Some have commented and opined on why the rupee is sliding, what’s so good about the rupee sliding and what’s so bad about the rupee sliding.

If we start from the commonly used data for understanding the rupee journey, we see in the below chart that, the rupee has steadily declined from the year 2008 to 2022. Starting from the Global financial crisis in 2008, then to the taper tantrum when the US fed started reducing the liquidity in the market, to the recent phenomenon of the covid pandemic, you can see how the dollar jumped from 40 Rs a dollar to 80 Rupees to Dollar.

If we look at the rupee and dollar rate in the narrow view shown, it’s a no-brainer that anyone would think that it is a doomsday kind of situation for the Indian currency. However, the data conceals more than it reveals, because what we want to understand is what is going on with the rupee.

Well, to begin with as I had mentioned in my earlier piece, the dollar index has risen sharply since the fed ( US) has begun tightening the monetary policy. The dollar index has strengthened almost 15% in the last year. As a consequence of the steep incline of the dollar against the advance and the emergent economies, the rupee has also suffered. And all this has a lot due to the pretty aggressive rate hike of the US fed in past months. This notion that the inflation was transitory in the US proved not to be true and once market understood that , the dollar began to strengthen reflecting the growth and inflation differential.

To Dig deep, if we compare the Indian Rupee to other emerging markets, we can see that the Indian currency is one of the better-performing currencies against the USD. When we say we are down 7% it’s against the backdrop of the dollar index and most emerging markets including China and its currency have weakened more against the dollar. This is the first layer to understanding about rupee downfall.

The next layer is, why are we focused on dollars only? If we think from a competitive perspective, India’s trade basket is very diversified. We Export and import from the Euro Area, China, the UAE, Saudi Arabia, and around 40 countries. So why are we so fixated on the dollar? What we need to do is look at how our exchange rate has done against our trading partners, not just against the US dollar. US Constitutes around 12% of our trade weight, and 18% of our export weight( Source: RBI). A lot of goods are invoiced in US dollars, so maybe the weight of the dollars in the basket needs to be higher, but we should not be so obsessed with one currency.  Rather we should look how our currency has performed against all our trading partners. So if we are importing goods from China , it is invoiced in Chinese yen , then it matters how rupee did against Yen . The RBI comes up with the exchange rate which is called as Nominal Effective exchange Rate , Over the much of last 3 years this index it has been flat , this means the rupee has not weakened with respect to the currencies of all the trading partners for past 3 years.

The Third thing, we can look at is the real exchange rate.Lets’ assume we have a pen here in India, which costs around 75 Rs in India and 1 USD in New York. In Economics there is a concept of purchasing power parity, which means that one good should cost the same in any two countries, even if the exchange rates are different. If the exchange rate of INR to USD is 75 that means in  75 Rs I should be able to buy a pen in India and 1 Dollar I can buy the pen in the US otherwise there is an Arbitrage. Let’s assume, that India has a 5% inflation rate and the US has zero inflation rate  ( I know, it’s laughable to say that for the US now, but generally the inflation in the US has been 0%-2% only  ), after one year the same pen in India will cost 78 Rs and In US it is still one dollar. If the market exchange didn’t  move , in a way India becomes a little uncompetitive in exports , you would rather import this pen from US. That’s why one should look at real exchange rate and not just nominal exchange rate . This exchange rate is called as Real effective Exchange rate ( REER) . As shown below the REER of India has improved over time , the trade weighted real exchange rate for India has been rising upwards since past few years.

So we see, I began by talking about the Dollar – Rupee curve which showed that the Indian rupee is going down, it has been weakening , but when you peel all the layers of the onion you will find that on the trade weighted basis , the rupee is actually strengthen over many years . This is not a surprise though, because REER is a function of productivity differential growth rates, which is much higher than our trading partners.

As countries grow  , their REER tends to appreciate, but the debate that economists should be having is why  has  REER  appreciated and to what extent and is it because of the fundamentals or something else?

If we look at our forex reserve, we have plenty of ammunition, external debt is due, but it is mostly corporate debt that will be restructured. If the global growth is not slowing down, then these fundamentals will help India to reduce its current account deficit, but since the US and Europe are already in recession, it might be a little challenging in the short run for us for exporting and managing our CAD ( current account deficit ) targets.

To summarise, as an economy we have been doing pretty well, growth is there to see,  sometimes data can reveal much less than it can hide.

Written By: Ankur Kushwaha, Sr. Consultant, Invest Punjab | Govt. of Punjab.

DISCLAIMER: Views expressed are personal.

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