Commentary: Anxiety over a strong rupee By Andy Mukherjee Bloomberg News MONDAY, AUGUST 22, 2005 http://www.iht.com/articles/2005/08/21/bloomberg/sxmuk.php# In Oscar Wilde's play, "The Importance of Being Earnest," Cecily Cardew is advised by her governess, Miss Prism, to study economics without dwelling on the fall of the rupee. "It's somewhat too sensational," the governess says. Now, in a reversal, it is the rise of the Indian currency that is being viewed as sensational. Murmurs have begun that the rupee is overvalued because its so-called real effective exchange rate has appreciated to a point where, unless the central bank stuffs many more dollars into its reserves to stem the rise, India's export competitiveness may be jeopardized. The anxiety is unwarranted. At 43.57 to the U.S. dollar, the rupee may be 11 percent stronger than in May 2002. Still, the Indian currency continues to be undervalued and if one indicator says otherwise, then it is probably time to find a better yardstick. To compute the real effective exchange rate, a country's exchange rates with other major currencies are deflated by the inflation difference. Then, a trade-weighted average of these "real" exchange rates is calculated. A single index is created using a base period. Economists say that any appreciation in the real effective exchange rate from its value in the chosen base year, either through a nominal increase in the home currency or a rise in local inflation, represents a loss for the country's export competitiveness. However, if a currency happened to be largely undervalued in the base year, then a small gain in the real effective exchange rate would not make it overvalued. That is precisely what has happened in India, where the central bank's five-country real effective exchange rate, tracked on a daily basis by J.P. Morgan Chase, covers the rupee's exchange rate with currencies of the United States, Japan, Germany, Britain, and France. The index showed 11 percent overvaluation for the home currency on July 27, compared with its base-year value in 1994. Since then, the misalignment has eased somewhat to 8.75 percent. Among the 400-odd currency traders who assembled recently in the southern Indian coastal town of Kochi for their annual meeting, there was very little support for the view that the rupee is overvalued. However, there was an equally strong perception that the central bank used the real effective exchange rate - a malfunctioning thermometer indicating fever where none exists - as an anchor for the currency's value. "It's generally believed in the market that the Reserve Bank is comfortable with plus or minus 5 percent to the equilibrium level," said Venkat Thiagarajan, senior foreign-exchange dealer for Reliance Industries, India's biggest company not owned by the state. Exports from the United States, Britain or Japan hardly compete against Indian-made goods. How can an index that does not even consider competition, like from China in garments, measure competitiveness? Besides, Indian exports have not stalled. They have grown 21 percent from a year earlier in the four months ending in July. The Reserve Bank's priority should be to tame inflation, which is being held at an artificially low 3.8 percent by a government reluctant to pass on increases in fuel prices to Indian consumers. A stronger currency will help keep prices of imported goods low. Should inflation pressures abate, India's central bank would still be unwise to revive the "ghost" of the real effective exchange rate, as Thiagarajan at Reliance termed the indicator. Doing so would only make the government delay addressing some of the obstacles to becoming more competitive - bad infrastructure, rigid labor laws and red tape. "I would not like the Reserve Bank to take on the entire burden of trying to accommodate the other inefficiencies in the system," said Subir Gokarn, chief economist at Crisil, India's biggest rating company. When Wilde was writing his 1895 play, India had only recently stopped free coinage of silver under distress. It would take the country another four years and more misery to unlink the rupee from the metal whose prices had slumped after the 1873 decision by the U.S. Congress to give up the silver dollar in favor of an effective gold standard. If the silver standard proved to be disastrous for India in the late 19th century, preventing steady appreciation in the currency for the sake of the real effective exchange rate will be no less troublesome. This will keep inflation higher than it should be and involve additions to the country's bloated $142.6 billion in foreign-exchange reserves, with the risk of a sharp valuation loss if the dollar tumbles. Silver can at least be used to make spoons. The real effective exchange rate does not exist outside of computer spreadsheets. In Oscar Wilde's play, "The Importance of Being Earnest," Cecily Cardew is advised by her governess, Miss Prism, to study economics without dwelling on the fall of the rupee. "It's somewhat too sensational," the governess says. Now, in a reversal, it is the rise of the Indian currency that is being viewed as sensational. Murmurs have begun that the rupee is overvalued because its so-called real effective exchange rate has appreciated to a point where, unless the central bank stuffs many more dollars into its reserves to stem the rise, India's export competitiveness may be jeopardized. The anxiety is unwarranted. At 43.57 to the U.S. dollar, the rupee may be 11 percent stronger than in May 2002. Still, the Indian currency continues to be undervalued and if one indicator says otherwise, then it is probably time to find a better yardstick. To compute the real effective exchange rate, a country's exchange rates with other major currencies are deflated by the inflation difference. Then, a trade-weighted average of these "real" exchange rates is calculated. A single index is created using a base period. Economists say that any appreciation in the real effective exchange rate from its value in the chosen base year, either through a nominal increase in the home currency or a rise in local inflation, represents a loss for the country's export competitiveness. However, if a currency happened to be largely undervalued in the base year, then a small gain in the real effective exchange rate would not make it overvalued. That is precisely what has happened in India, where the central bank's five-country real effective exchange rate, tracked on a daily basis by J.P. Morgan Chase, covers the rupee's exchange rate with currencies of the United States, Japan, Germany, Britain, and France. The index showed 11 percent overvaluation for the home currency on July 27, compared with its base-year value in 1994. Since then, the misalignment has eased somewhat to 8.75 percent. Among the 400-odd currency traders who assembled recently in the southern Indian coastal town of Kochi for their annual meeting, there was very little support for the view that the rupee is overvalued. However, there was an equally strong perception that the central bank used the real effective exchange rate - a malfunctioning thermometer indicating fever where none exists - as an anchor for the currency's value. "It's generally believed in the market that the Reserve Bank is comfortable with plus or minus 5 percent to the equilibrium level," said Venkat Thiagarajan, senior foreign-exchange dealer for Reliance Industries, India's biggest company not owned by the state. Exports from the United States, Britain or Japan hardly compete against Indian-made goods. How can an index that does not even consider competition, like from China in garments, measure competitiveness? Besides, Indian exports have not stalled. They have grown 21 percent from a year earlier in the four months ending in July. The Reserve Bank's priority should be to tame inflation, which is being held at an artificially low 3.8 percent by a government reluctant to pass on increases in fuel prices to Indian consumers. A stronger currency will help keep prices of imported goods low. Should inflation pressures abate, India's central bank would still be unwise to revive the "ghost" of the real effective exchange rate, as Thiagarajan at Reliance termed the indicator. Doing so would only make the government delay addressing some of the obstacles to becoming more competitive - bad infrastructure, rigid labor laws and red tape. "I would not like the Reserve Bank to take on the entire burden of trying to accommodate the other inefficiencies in the system," said Subir Gokarn, chief economist at Crisil, India's biggest rating company. When Wilde was writing his 1895 play, India had only recently stopped free coinage of silver under distress. It would take the country another four years and more misery to unlink the rupee from the metal whose prices had slumped after the 1873 decision by the U.S. Congress to give up the silver dollar in favor of an effective gold standard. If the silver standard proved to be disastrous for India in the late 19th century, preventing steady appreciation in the currency for the sake of the real effective exchange rate will be no less troublesome. This will keep inflation higher than it should be and involve additions to the country's bloated $142.6 billion in foreign-exchange reserves, with the risk of a sharp valuation loss if the dollar tumbles. Silver can at least be used to make spoons. The real effective exchange rate does not exist outside of computer spreadsheets.
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