Let’s appreciate the appreciating REER

India’s Real Effective Exchange Rate (REER) 

*data for July 2005

Base 1985=100 for 36-country basket

Base 2003-0-4=100 for 5-country basket

Source: RBI Bulletin

Virtually everybody will tell you that the rupee has depreciated enormously since 1990-91, when the dollar was worth Rs 19. Today it is worth Rs 44. Yet in one very real sense, the rupee has actually appreciated in the same period. If you look at the real effective exchange rate (REER) as measured by the RBI using a basket of 36 currencies, you will find that it was 75.58 in 1990-91, dipped to a low of 57.08 in 1992-93, but then rose steadily to 76.95 in 2004-05. This level was higher than in 1990-91. Even more impressive, the REER moved up sharply in the current year, touching 81.65 in June.

You get a very different picture from the REER as measured by the RBI’s 5-currency basket (the top OECD ones). This shows a sharp fall from 141.99 in 1990-91 to 100.4 in 1993-94. The RBI has sought ever since to keep the 5-currency REER at around 100, plus or minus a few percentage points. In 2004-05, the REER was very much in this band, averaging 102.3. But this year it rose sharply to 110.84 in July.

Which of the two currency baskets is more relevant? I suspect the 36-country basket is more relevant, since it covers many of India’s export competitors in the Third World. India’s principal exports do not compete against those of the USA or Europe or Japan. They compete mainly against other Third World exports, above all China’s. On the other hand it is the Chinese yuan has virtually been tied to the dollar for a decade. Also, the base year (2003-04) for the 5-country index is up-to-date, while the base year for the 36-country basket (1985) is rather obsolete, and so more prone to error. So, there is something to be said for both baskets.

Be that as it may, I am struck that any basket at all could show the rupee stronger today than in 1990-91. There is some underlying strength in the rupee that most observers have missed.

This makes even more remarkable the recent spurt in India’s merchandise exports. Earlier episodes of fast export growth were invariably based on a falling rupee. For instance, exports rose 88% in the five years between 1991-92 and 1996-97, but the rupee fell sharply in that period.

By contrast, exports are all set to increase 110% in the five-year period 2001-02 to 2005-06, but the rupee has strengthened appreciably in this period. Never before have exports boomed in the face of currency appreciation. This is a true sign of a rising economic power. It means that productivity growth is so strong that exports can overcome the handicap of a rising exchange rate.

For the benefit of non-expert readers, let me explain what the real effective exchange rate is. Lay folk think of the exchange rate as the rupee’s value against the dollar. But that is an imperfect measure of export competitiveness, since our exports to go countries other than the US, the dollar itself fluctuates, and inflation rates vary widely across countries. So the RBI constructs an index called the real effective exchange rate (REER), adjusted for relative inflation in India and its trading partners. The RBI publishes two indices for the REER, one based on a basket of five currencies (the top OECD countries) and another using a basket of 36 currencies.

Why has the RBI sought for a decade top keep the 5-currency REER at around 100? Mainly to keep Indian exporters competitive. Huge inflows of remittances, foreign portfolio investment and foreign direct investment have in recent years flooded India with far more dollars than needed for imports and other foreign payments. This dollar flood would have caused the rupee to appreciate in a free forex market. However, the RBI has steadily purchased billions of dollars to prevent the rupee from appreciating. In the process, it has accumulated huge reserve, vastly in excess of any conceivable prudential need. The real reason has been to keep the exchange rate competitive.

Now, I think this exchange rate policy served Indian exporters well during and after the Asian financial crisis, which was marked by huge devaluations by our export rivals. The struggle to survive forced the same exporters to greatly improve their productivity. We are now reaping the reward. We are enjoying an unprecedented export boom in not only software/BPO but merchandise exports too. And this has continued in the face of a sharp rise in the REER this year.
Now, the rupee has slipped in the last two months against the dollar. This may not be entirely due to RBI intervention. It may also be due to high oil prices and booming non-oil imports, which have created a record trade deficit of over $ 6 billion in the latest quarter.

What are the implications for RBI policy? Its buying of dollars has imposed considerable costs on the economy. It pays for dollars in rupees, hugely boosting the money supply. To prevent this from causing inflation, the RBI mops up the excess rupees through what is called sterilization: it sells its holdings of relatively high-interest securities. The end result is that the RBI exchanges high-interest government securities for low-interest foreign securities. This entails a loss of billions of dollars per year.

Today, there is a good case for the RBI to relax its traditional policy of keeping the REER constant in terms of the 5-currency basket. This policy has rendered good service in years past, especially during the Asian financial crisis. Besides, even while the 5-currency REER has been kept stationary, the 36-currency basket has steadily appreciated. This cannot be called a status quo policy.

However, the time seems ripe for the RBI to relax on forex intervention. Indian exporters have become more productive and more able to withstand rupee appreciation. So, let the rupee float upward. The whole country will benefit from the consequent fall in inflation, as cheaper imports drive down prices. Remember, the main function of a central bank is inflation control. Forex policy is less important, and should aim among other things to reduce inflation. The RBI needs to get its priorities right.