What should be the ideal exchange rate? There is clearly no easy answer here as there are a number of factors that go into the determination of the exchange rate starting from the fundamentals to elements such as sentiment, NDF market, RBI’s position, expectations, global cues etc.
The real effective exchange rate has often been used to define the appropriate exchange rate level where relative inflation rates are brought in and it is assumed that the market is savvy and takes into account this factor in the background. If the REER is strengthening while the NEER is static, then it is assumed that the rupee is undervalued, as the rupee should have been appreciating.
The RBI on its part always maintains that it has no view on the rupee and is only interested in ensuring orderly movement meaning if there are disruptive forces, then it acts by either talking to banks or buying currency (which is the case today). What are we to make of it?
The REER concept in a way has limitations because it uses trade or exports as weights for calculating the index. While cumulative trade amounts to around $750 billion in FY14, the quantum of invisibles was around $450 billion (receipts plus payments) and capital account was another $75-100 billion. This means a fairly large part of the balance of payments — around 40% — would not be driven by relative inflation and by other factors.
To get a closer picture of how exchange rates are being driven, the relation with changes in forex reserves can be analysed. Theoretically, exchange rate is the result of the equilibrium of demand and supply for dollars, which is indicated by the change in reserves.
Ex post, if the forex reserves have increased, then the exchange rate should have appreciated with a negative sign and vice versa. Data for the past 60 months has been used to draw an inference through a simple regression equation. The advantage of using changes in forex reserves is that RBI action also gets subsumed in this relation because if the RBI is buying dollars in the market, then the forex reserves held by it should increase, and in case it sells to stabilise the rupee, then the reserves must dip.
The results are quite revealing. First, the coefficient of correlation is quite strong at negative 0.50, which means there is fairly significant association between movements in forex reserves and rupeedollar movements. The negative sign goes with appreciation of currency when reserves increase.
Second, the coefficient of change in forex reserves is negative 0.00012, which broadly indicates that if $1000 million dollars come into the system, the exchange rate will appreciate by 12 paise. Third, the intercept, which covers all factors outside forex reserves change, is 0.32, meaning there is a natural tendency for the currency to depreciate and unless there is a very large inflow which can overwhelm this intercept, the rupee will continue to fall.
Last, the coefficient of determination called rsquare, which explains the proportion of the change in the exchange rate that can be explained by the changes in forex reserves, is around 25%. When quarterly data is used instead of monthly data, similar results are obtained with a slightly stronger relationship with r-square rising to 0.36.
All this means that while one can be searching for some order or pattern in the movement in exchange rates, they are fairly random. The physical movement of dollars is able to only partly explain the changes in the exchange rate. As a corollary, RBI intervention through physical sale or purchase has a limited impact and has to be continuous and considerable to actually move the currency.
In fact talking to banks could be more effective. This also probably also explains why the movement in the rupee does not go hand in hand with movement in FII flows. The sentiment factor definitely is critical here.
This being the case, the RBI is right when it warns companies to hedge their forex exposure as even its own actions will have limited influence over the currency and while there is a belief that the RBI is happy to have the rate between Rs 60-62 a dollar, it cannot really guarantee the same through action.
Ironically, it is the sentiment or belief that the RBI will defend the rupee either ways, which is keeping the rupee stable. With the imponderables exerting more influence on the currency they can pressurise the P&L accounts of corporates. Even the REER is a weak guide to predicting future exchange rates. Quite clearly, hedging such exposures should become a habit.
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