Ashwani Mahajan and Phool Chand

Based on the analysis of the economic performance of India during 2014–16, the economic indicators suggest that the rupee should have appreciated, not depreciated. The depreciation of the rupee before January 2017 was an outcome of non-fundamental factors, such as speculation in the currency market.

Since the advent of globalisation, currencies of least developed, developing, and emerging economies, barring a few exceptions, have been constantly depreciating vis-à-vis the Ameri- can dollar. If we look at the exchange rate of rupee vis-à-vis the dollar, in the last one year, the dollar has been appreciating, especially against the Indian rupee. In the past, appreciation of the dollar vis-à-vis the currencies of developing countries was being explained in more ways than one. It was argued that these currencies are getting weaker because these economies have been facing huge trade deficits, high rates of inflation, increasing external debt, weak performance of domestic production, etc. Upheavals in the exchange rates were being explained in terms of capital and financial outflows, global economic scenario, economic, technical, and political factors, etc, resulting in volatile exchange rates, which could hamper international trade and even economic stability.

These arguments were universally accepted to explain the exchange rates across the globe. We find that the rupee has depreciated from `59.64 to `68.12 per dollar between April 2014 and December 2016. Some analysts even argued that the rupee is still overvalued and there is a need for the rupee to depreciate further to stem the downfall in exports. Exporters’ lobbies made use of this argument to pressurise the government to weaken the rupee in the name of encouraging growth in exports. This article seeks to examine whether there is a case for weakening the rupee or, on the contrary, there is a possibility of making the rupee stronger. Those who think that the rupee is overvalued, legitimise its constant depreciation over the years. Their argument may be true for what happened in the last two decades. However, developments in the last few months make us question this stand.

The reasons given for the appreciation of the dollar were the improvements in the macroeconomic variables in the United States (US), including acceleration in gross domestic product (GDP) and employment growth. We find that as per Trading Economics, the US economy advanced on an annualised 2.1% in the fourth quarter of 2016, higher than 1.9% in the previous estimates. Unemployment rate had fallen down to 4.5% in the first quarter of 2017 from the previous estimate of 4.7%. Inflation rate in the US is expected to be 2.4% in the first quarter of 2017, lower by 0.1 percentage points as compared to the previous quarter. The foreign exchange reserve is likely to be around $1,188,200 million at the end of the fourth quarter of 2017. There are people who believe that the dollar would continue to be strong in the near future as well, when the US Federal Reserve (Fed) starts raising interest rates. Increase in policy interest rates by the Fed would make people shift their funds from elsewhere to the US, which in turn could mean further depreciation of other currencies, including the rupee.

Another reason given for the strength of the dollar was improvement in the international payment position of the US. The US trade gap has narrowed to $43.57 billion in March 2017, from a $46.96 billion deficit in February 2015. Moreover, it is likely to be around $38 billion in the next quarter. Relatively strong economic performance and rising interest rates would allow the dollar to continue to strengthen against key trading partners, it was argued. According to FactSet Economic Estimates, the dollar was expected to appreciate by 6.5% versus the euro in 2016 (1.086 to 1.020), 5.6% as against the yen (120.3 to 127), and 3.2% as against the yuan (6.494 to 6.7). Meanwhile, the dollar was expected to weaken slightly against the Canadian dollar (4.1%) and the pound (3.0%). However, contrary to their forecast, during the current financial year, the value of the dollar is declining vis-à-vis all these currencies.

Was the Rupee Overvalued?

It is true that the US dollar had been continuously appreciating against the rupee till December 2016. Since the beginning of 2011, the rupee had depreciated by 49.4% as against the US dollar, moving from `44.70 per dollar at the end of December 2010 to `66.80 per dollar in December 2016. The rupee was at an all-time low of `68.85 per dollar on 28 August 2013.

However, it is to be noted that curren- cies of many BRICS (Brazil, Russia, India, China, and South Africa) nations had depreciated at a much faster rate. For instance, between 2011 and 2016, Brazil’s real had depreciated by 55%, South Africa’s rand by 53%, and Russia’s rou- ble by 53%. This implies that, though the rupee had depreciated against the dollar, it had actually appreciated against many other currencies. The only exception was that of China, whose currency had depreciated by only 0.5% during this period. Many other currencies had also depreciated vis-à-vis the dollar since 2011. For instance, the Indonesian rupiah has depreciated by 34%, the Malaysian ringgit by 27%, the Thai baht by 3.5%, and the Philippine’s peso by 7% up to April 2016.

Between 2011 and 2016, the Dollar Index—which measures the dollar against a basket of trade weighted currencies—had gained 26.3%. Much of this appreciation came in 2014 and 2015 when the index gained 12.8% and 10.5% respectively.

Was the rupee overvalued? To answer this question, we must look at the variables that tend to determine the strength of any currency. The strength of a currency is usually closely related to the performance of an economy. The major reasons behind depreciation of the rupee would be: (i) dollar gaining strength against all other currencies; (ii) mounting current account deficit; (iii) mounting capital account deficit; (iv) rupee speculation and central bank’s inability to manage the exchange rate. If all or some of these reasons are satisfied, the rupee would depreciate. The first three reasons are fundamental in nature, whereas the fourth, speculation, is not.

The dollar could appreciate if macroeconomic conditions in the US are strong. If India does not have strong macroeconomic fundamentals, the rupee would tend to decline vis-à-vis the dollar.

Current account deficit plays a significant role in finding the true value of any currency. If a country suffers from slowing of exports, higher oil prices, and higher gold import, then the upcoming pressure of such variables pushes the currency down.

Similarly, capital account deficit will also put pressure on the currency to decline. With lower foreign direct investment and higher external commercial borrowing (ECB), the rupee will definitely tend to decline because of dampening of the foreign exchange reserve of the country.

Rupee speculation refers to the flow of funds (or capital) from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. Once currency traders and speculators realise that India’s central bank is unable/unwilling to manage its exchange rate, and reduce the adverse impact on its currency, they may enter the market in a big way to sell the rupee. As a result, the rupee may devalue more than it should.

So, there is a need to see whether the rupee in reality was overvalued. It would have been, if fundamental factors had not been performing well. Otherwise, the Indian currency was wrongly interpreted by a number of economists, including Raghuram Rajan, the former governor of the Reserve Bank of India (RBI).

Macroeconomic Conditions in India

India’s GDP advanced 7% year-on-year in the last three months of 2016, slowing from an upwardly revised 7.4% rise in the previous quarter, but beating the expectations of a 6.4% growth. The expan- sion was mainly driven by a surge in public spending and agricultural growth. Inflation rate in India was recorded at 3.81% year-on-year in March 2017, reaching its lowest since September 2016. It is much lower than what it was in 2014, at around 8.3%.

India recorded a current account defi- cit of $8.5 billion in the last quarter of 2016–17 (January–March 2017), which was higher than the current account deficit of $7.1 billion during the previous quarter. From July–September 2016, current account deficit was recorded at $8.7 billion. Further, we note that during the third quarter, there was a surplus of $4.1 billion on the overall balance of pay- ments. Foreign direct investment (FDI) received between March–December 2016 was recorded at $35.84 billion, which was substantially higher than $29.44 billion of FDI received in the corresponding period of 2015. The rising trend of FDI is believed to have continued in the last quarter of 2016–17 as well. However, it is surprising that the rupee continued to depreciate despite improvement in the balance of payments in the third quarter and the record FDI received in 2016. This, when the rupee appreciated despite an increase in current account deficits in the last quarter of 2016–17.

Improvements in the balance of payments situation, record capital flows, and improving terms of trade all have culminated in increasing India’s foreign exchange reserves, which have increased

 

 

from $361,990 million in the fourth quarter of 2015–16 to $365,287 million in first quarter of 2016–17. Now it is around $370,000 million in the last quarter of 2016–17. Along with this improvement in foreign exchange reserves, we also see a reduction in foreign debt from $484,300 million in the third quarter of 2016–17 to $456,100 million in the fourth quarter of 2016–17.

Since 2014, India’s macroeconomic variables are performing well. The ultimate gain of such well-performing variables leads to an upswing in the stock market. The Bombay Stock Exchange (BSE) Sensex reached an all-time high of 29,974.24 in April 2017. It was at 22,417.80 in April 2014.

Exports from India jumped 27.6% year-on-year to $29.2 billion in March 2017, reaching a high since March 2014. Sales of goods excluding petroleum and gems and jewellery went up by 25.5%.

This shows that depreciation of the rupee is not linked with competitiveness in exports. The Indian rupee appreciated by 5% from January 2016 to March 2017, even as exports have increased significantly in the same period.

Rethinking Export Incentives

It would be appropriate to quote the commerce minister Nirmala Sitharaman signalling a fundamental rethink in the government’s view on the exchange rate as the sole tool for incentivising exports. She recently said, “although strengthening of rupee by itself will be worrying today, I will contexualise it in the Indian economy’s overall strengthening position” (Padmanabhan 2017).

After going through the performance of India’s macroeconomic indicators, one can logically conclude that the rupee should have appreciated rather than depreciated, even before January 2017, as all these factors indicate strengthening of the rupee.

If we look at the top four currencies of the world—the dollar, the pound, the euro, and the yen—in the last two years, the rupee has depreciated vis-à-vis the dollar (Figure 1), but has appreciated against the pound (Figure 2), the euro (Figure 3), and the yen. Overall, if we look at the levels at the end of 2015, rela- tive to those a year and two years earlier, we find a marginal appreciation as against the pound, significant appreciation as against the euro, and a mixed picture relative to the yen.

The rupee appreciated marginally by 0.423% between 2014 and 2016 against the yen as well. Interestingly, the yen had depreciated against the rupee by 11.42% between 2014 and 2015. The rupee has appreciated by 18.77% and 15.24% between April 2014 and Decem- ber 2016 against the pound and the euro respectively (Table 1).

Table 1: Exchange Rates in Rupees                    Date Dollar   Pound         Euro 25 April 2014        61.11 102.70 84.52

30 December 2016 68.12     83.42    71.62

Source: Reserve Bank of India.

 

 

 

 

Arbitrage in Currency Market

The appreciation of the dollar with respect to the rupee is non-fundamental in nature. Even if we accept that the US economy has started performing well in terms of GDP growth and employment, economic indicators show that the Indian economy has also been performing well, in fact better than the US. Moreover, the Indian currency has shown an upward swing with respect to the euro and the pound. What could be the possible explanation for the same? Certainly, exchange rates cannot be explained in terms of economic fundamentals, as we see much better performance of the Indian economy and the balance of payments position.

How and why was the rupee weak vis- à-vis the dollar till December 2016, when it was performing well against the pound and the euro? The rupee depreciated by 11.47% vis-à-vis the dollar between April 2014 and December 2016. The anomaly is that it had appreciated by 18.77% and 15.28% against the pound and the euro, respectively, during the same period.

The explanation of this trend lies in the presence of speculation/arbitrage trading in the currency market at the global level. People had been buying either the euro or the pound in exchange for the rupee, and then selling such currencies to buy the dollar. After holding the dollar for some time, they would sell the dollar in India and convert it into the rupee. In this process, the demand for the dollar would continue to exist at the global level, and make the dollar appreciate. By selling the dollar in India, people were making speculative gains over a period of two years (April 2014 to December 2016). The opportunity to gain more occurred due to the dampening of the pound and eurocurrencies as against the rupee. So, despite the presence of well performing macroeconomic variables, the rupee depreciated against the dollar due to speculative opportunities prevailing at the global level.

 

More Strength to the Rupee

Till December 2016, the rupee was depreciating drastically due to the inap- propriate attitude of policymakers towards the overvaluation of the rupee. This is why the rupee’s value tended to decline. However, the issue of rupee depreciation was not analysed sufficiently with respect to non-fundamental reasons, such as speculation. We have seen that, from April 2014 to December 2016, there was a huge opportunity for the speculators to make possible gains by trading in cur- rency markets. Our own understating is that if speculative gains from arbitrage diminish and macroeconomic variables are encouraging, the rupee will show an upward trend against the dollar. In Table 2, we find that, after December 2016, the rupee started appreciating against the dollar and maintained its upward stride against other major currencies.

This also shows that less speculation led to appreciation of the rupee. The rupee had depreciated by 11.47% till December 2016, and has now appreciated by 5% till March 2017. This happened due to less opportunity for speculative gain in the currency market. Moreover, it has appreciated further by 21.24% and 18.08% against the pound and the euro, respectively.

 

REFERENCE                                                                            

Padmanabhan, A (2017): “Government Signals Re-think on Rupee as Export Anchor,” Mint, 17 April