The rupee is no longer all that overvalued. Its significant fall against the dollar as well as other major currencies after July has resulted in a substantial correction of its ‘real' exchange rate to near normal levels.
This is brought out clearly in the Reserve Bank of India's latest data relating to the rupee's real effective exchange rate or REER.
The REER measures the bilateral trade-weighted average exchange rate of the rupee against a basket of currencies (US Dollar, Euro, Pound, Yen, Chinese Renminbi and Hong Kong Dollar), while adjusting for the inflation differentials vis-à-vis the countries concerned.
According to the RBI estimates, the rupee's REER as on November 25 stood at 103.52 against a base level of 100 for 2004-05. It means that the rupee has since 2004-05 appreciated by 3.52 per cent in real effective terms against major world currencies. Given that in July this year, the REER averaged 118.31, it points to a large correction in a matter of four months.
A country's currency is overvalued when its exchange rate does not fall at the same pace at which domestic price levels go up.
This was the case until recently in India, where the wholesale price index-based inflation rate has been ruling at over eight per cent since January 2010. On the other hand, the rupee's average exchange rate against the US dollar actually fell from nearly Rs 46 to below Rs 44.5 between January 2010 and July 2011.
What this effectively translated to was a situation where the rupee, even while experiencing a steady erosion of domestic purchasing power, was gaining in strength as far as buying dollars was concerned. In other words, a lamb at home and a tiger abroad.
But that has since changed, with the rupee falling from as high as Rs 43.95-to-the-dollar on July 27 to the current level of Rs 52.4. Between July 27 and now, the rupee has also shed against the euro from Rs 63.67 to Rs 69.94.
In the coming days, with inflation expected to come down and the pressure on the rupee to continue on account of a drying up of forex inflows, analysts expect the REER to only go down further – as it did in the aftermath of the collapse of Lehman Brothers in September 2008 and the global economic crisis that followed.