The rupee’s continuing slide raises the natural question: How much more? Is there an equilibrium exchange rate, reflecting its ‘real’ value, that the rupee may eventually settle on? Consider what economists refer to as the real effective exchange rate or REER. It is a measure of the trade-weighted average exchange rate of the rupee against a basket of currencies after adjusting for inflation differentials vis-à-vis the countries concerned and expressed as an index number relative to a base year. Taking 2004-05 as the base with a value of 100, the average REER of the rupee against six currencies — the US dollar, euro, pound, yen, Chinese renminbi and Hong Kong dollar — worked out to 114.91 in 2010-11, 111.86 in 2011-12 and 105.46 in 2012-13. It meant that the rupee had strengthened against these currencies after correcting for the higher inflation levels in India. It was an ‘overvalued’ currency, in other words.
But since June 2013, the six-currency trade-weighted REER has dropped below 100; the latest number for July was 96.94. It implies the rupee had already substantially corrected by June, when its exchange rate averaged about 58.4 to the dollar. Therefore, at the existing Rs 63-64 levels, the rupee is an ‘undervalued’ currency, given that its ‘real’ parity is around 58 to a dollar. But this is all very well in theory. In practice, the price of a commodity is usually determined by the law of supply and demand and rarely by its underlying ‘value’. The same is true of the rupee. For much of the last decade, the rupee traded strong beyond what its fundamentals justified. Today, it is the other way round. The rupee may be ‘undervalued’ in theory. But in a bear market where everyone wants to ‘short’ it, the rupee will remain under pressure.
What policymakers can hope for in such an environment is for the market-determined exchange rate to correct itself as it did when the rupee was overvalued. No one can, of course, predict when this convergence will happen. One thing the Reserve Bank of India (RBI) could do — as Ashima Goyal of the Indira Gandhi Institute of Development Research has suggested in a recent column in this newspaper — is to come out with more frequent pronouncements, based on its research estimates, on equilibrium-based exchange rates. These may contribute to influencing market expectations and signalling the dangers of betting against the rupee beyond certain limits. Instead of merely publishing data on REER, which not many fully understand, the RBI could explicitly indicate equilibrium exchange rates corresponding to these indices on a regular basis. This kind of a ‘mind-game’ approach, rather than physical market intervention, could be more effective in stabilising the rupee.