2013-14 has been a good year for the external account and a lot has been done to straighten it after the pandemonium caused by a widening CAD and news of tapering by the Fed in May 2013. But with CAD coming down to probably less than 2% of GDP and the tapering impact receding, we are in a position where we can talk of RBI buying dollars and providing support for exports. To what extent will this work?
RBI has recently brought out indices for the nominal effective exchange rate (NEER) and export- weighted real effective exchange rate (REER) based on the CPI. So far it was based on the WPI and presented with 2004-05 as the base year. The whole idea was that when we are talking of REER, we are comparing the inflation differential between India and the trading partners, and ideally one should look at the basket of 36 currencies rather than 6. The difference this time is that since we have a new CPI number series, the same can be used for comparison purposes as all global indices are based on the CPI.
The concept of REER will actually throw some light on how responsive our exports would be to the change in exchange rate and whether there is truly a relationship between the two. The table gives the changes in the exchange rate measured in four ways. The first is the plain average exchange rate for the dollar with a positive sign, indicating appreciation and negative a depreciation of the rupee. The NEER is for the 36 country index with 2004-05 as base year. The two REERs are based on the WPI and CPI, respectively, while the growth in exports is in dollar terms.
There is a difference between the rupee value change against the dollar and NEER. As we move from the dollar rupee to the REER-CPI, the extent of change also diminishes quite sharply. In fact, in the past three years, the rupee cumulatively declined by almost 30%. Against this decline, REER shows a change of 8.5%. This indicates that high inflation in the country does, to a large extent, explain also the movement in exchange rate and, hence, the depreciation level is moderated to a large extent.
As a corollary, the potential advantage of export competitiveness also comes down sharply. Therefore, the assumption normally made that depreciation in rupee brings about this advantage does not quite look that perceptible when the REER is considered. The difference in rupee movement as shown by REER is not too stark, with FY10 being the only exception when CPI-based index showed rupee appreciation even while the NEER and REER-WPI indicated a decline in value of the rupee. In the last two years, the difference has been around 250-300 bps, which is probably not that significant.
Another observation is that there is no clear relationship between growth in exports and exchange rate. Of the five years, when exports grew by above 20% p.a, there was appreciation in rupee in three years in both real and nominal terms. Also, a sharp depreciation in nominal terms of the rupee vis-a-vis the dollar has not quite pushed up exports. A part of the explanation can be that REER does not show significant gains in terms of price advantage for our exports, thus blunting the impact.
If the rupee decline is controlled through policy measures, then after making adjustments for the REER, the cost advantage would get diluted. This means that as long as inflation is high in India relative to global prices, then one can rule out any such advantage. If this were so, then the central bank should not really think of letting the rupee slip for the sake of exports as there are several imponderables involved in this relation working out. However, if the purpose is to accumulate dollars and hold the currency steady, then it would be a different story with little expectation of exports getting a lift.
RBI has recently brought out indices for the nominal effective exchange rate (NEER) and export- weighted real effective exchange rate (REER) based on the CPI. So far it was based on the WPI and presented with 2004-05 as the base year. The whole idea was that when we are talking of REER, we are comparing the inflation differential between India and the trading partners, and ideally one should look at the basket of 36 currencies rather than 6. The difference this time is that since we have a new CPI number series, the same can be used for comparison purposes as all global indices are based on the CPI.
The concept of REER will actually throw some light on how responsive our exports would be to the change in exchange rate and whether there is truly a relationship between the two. The table gives the changes in the exchange rate measured in four ways. The first is the plain average exchange rate for the dollar with a positive sign, indicating appreciation and negative a depreciation of the rupee. The NEER is for the 36 country index with 2004-05 as base year. The two REERs are based on the WPI and CPI, respectively, while the growth in exports is in dollar terms.There is a difference between the rupee value change against the dollar and NEER. As we move from the dollar rupee to the REER-CPI, the extent of change also diminishes quite sharply. In fact, in the past three years, the rupee cumulatively declined by almost 30%. Against this decline, REER shows a change of 8.5%. This indicates that high inflation in the country does, to a large extent, explain also the movement in exchange rate and, hence, the depreciation level is moderated to a large extent.
As a corollary, the potential advantage of export competitiveness also comes down sharply. Therefore, the assumption normally made that depreciation in rupee brings about this advantage does not quite look that perceptible when the REER is considered. The difference in rupee movement as shown by REER is not too stark, with FY10 being the only exception when CPI-based index showed rupee appreciation even while the NEER and REER-WPI indicated a decline in value of the rupee. In the last two years, the difference has been around 250-300 bps, which is probably not that significant.
Another observation is that there is no clear relationship between growth in exports and exchange rate. Of the five years, when exports grew by above 20% p.a, there was appreciation in rupee in three years in both real and nominal terms. Also, a sharp depreciation in nominal terms of the rupee vis-a-vis the dollar has not quite pushed up exports. A part of the explanation can be that REER does not show significant gains in terms of price advantage for our exports, thus blunting the impact.
If the rupee decline is controlled through policy measures, then after making adjustments for the REER, the cost advantage would get diluted. This means that as long as inflation is high in India relative to global prices, then one can rule out any such advantage. If this were so, then the central bank should not really think of letting the rupee slip for the sake of exports as there are several imponderables involved in this relation working out. However, if the purpose is to accumulate dollars and hold the currency steady, then it would be a different story with little expectation of exports getting a lift.
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