The Hindu Business Line : Changing view from REER window

FOREX market participants have often looked at the real effective exchange rate (REER) as the anchor around which the Reserve Bank of India maintains rupee's value. And perhaps rightly so, as the REER (the five-country index with 1993-94 base) has rarely breached the 95-105 band since 1998. Contrast this with the REER for a strong currency such as the dollar, which gyrated between 85 and 116 in the same period.

The belief in the REER band was somewhat shattered this year, when it has stayed above 105 since May. In July, it crossed the 110 level. That means the rupee was overvalued by 10 per cent in July, that is, if one believes that it was correctly valued in 1993-94. Even now the level of overvaluation persists at about 10 per cent.

Against this backdrop, the RBI has announced plans to come up with a new index, including two more currencies — of China and Hong Kong — in the basket. How different will the new REER be, and will it reinstate REER's position as the anchor for rupee's management?

The REER essentially looks at the external valuation of the rupee from a broader perspective than a mere rupee-dollar quote. The index is "effective" because it considers a basket of currencies and it is "real" because it is adjusted for inflation differential.

The currencies and their weights in determining the index are based on the relative trade flows with these economies. The logic of maintaining REER within a band is that an overvalued rupee hurts competitiveness of exports (and even the domestic industry), while an undervalued rupee is inflationary and gives undue protection to domestic industry.

It was believed that the RBI intervenes when the REER threatens to cross the band. That is, the RBI will push the rupee down if the REER approaches 105 and prop up the rupee if it gets close to 95. But this time, the RBI has not acted enough to push the REER back to sub-105 levels.

We tried to probe this phenomenon by examining whether the currently used index has become obsolete because of the changing trade patterns. After all, the extant REER weights are based on India's trade in goods with five major partners in the mid-1990s. We carried out an exercise to see if updating this model removes the signs of overvaluation. In our simulations, we considered more recent trade data besides considering the EU as a single bloc. We also included the trade patterns for two key services — IT and tourism.

Another simulation was to consider other important trading partners such as China, Hong Kong and the UAE, which incidentally have their currencies largely pegged to the dollar. In the simulation based on recent trade data, the weight of the euro in the REER basket went well past that of the dollar as it represents more economies now. In another simulation that included pegged currencies, the effective weight of dollar became more dominant.

But interesting was that the resultant REER was nearly insensitive to these starkly different weights of currencies. The extent of overvaluation for July went up or down by just about half a per cent in these simulations (see table).

Essentially, this result indicates that the inflation differential between India and the US and between India and the EU is fairly similar, and therefore, the REER does not react much to the changes in weights.

In another simulation, we used producers' price indexes (PPI) for calculating the REER instead of the conventional consumer price index (CPI) numbers. The purchasing power parity theory underlying the REER is applicable to the tradables rather than non-tradables.

The PPI is a better representation of the prices of tradables than the CPI. And the PPI-based inflation differential is relatively smaller. So, this simulation yielded about three points drop in the REER index, but still REER remained outside the traditional band.

The near-insensitivity of REER numbers to weights of currencies suggests that RBI's new index may not bring REER within its historical band by simply including two currencies that are largely dollar-pegged. But over a period of time, whenever China and Hong Kong float their currencies in a true manner and inch up, the new model will lower the REER numbers than what the RBI's previous model would have obtained.

For example, after including these two currencies, incorporating new weights and simulating with a 5 per cent appreciation of the two new currencies, the REER number for October 3 will fall to 109 from over 110. To that extent, the new REER could be more supportive of a stronger rupee.

But is the REER indeed an anchor for the RBI even today?

There are many arguments against using the REER as an indicator of the "correct" valuation of rupee. One major argument is that the REER focuses only on trade flows and ignores the flows on capital account.

It considers the inflation differential but ignores the interest rate differential (and also the sentiment differential!). The other major problem is that one has to impute the `correctness' to some level of valuation subjectively. Thus, if the rupee was actually undervalued in 1993-94, then it cannot be termed `overvalued' on the basis of the current REER.

So one radical possibility could be that the RBI has indeed junked REER. The other sober interpretation could be that RBI has become more tolerant because of other macroeconomic considerations like high commodity prices.

So, now RBI might be allowing a wider band or it might be tolerant of deviation from the band for a longer time period than in the past. Either way, the REER seems to have lost some degree of its predictive power as regards the future course of the rupee.

(The authors are with Aditya Birla Management Corporation. The views are personal.)

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