For a long time, the rupee stayed in a narrow range of movement against the US dollar. A few weeks ago, it began to appreciate, apparently to the surprise of many, if not all, market participants and has so far shown no signs of reversing this recent trend. From the perspective of market fundamentals, however, this trend is quite logical. India is in a
state of structural balance of payments surpluses, with the foreign exchange inflow substantially exceeding the demand for it, even taking into account the recent increase in outward investment by Indian companies and the more liberal limits on portfolio investment by resident Indians.
Under these conditions, the rupee can only appreciate. The one thing that can stop it from doing so is reserve accumulation by the RBI which is exactly how exchange rate stability was maintained until a few weeks ago.
Those market participants who were taken by surprise by the appreciation essentially believed that the RBI was permanently committed to preventing the rupee from appreciating, because this would hurt the country's export competitiveness. Virtually all our major competitors in the global market, certainly all the major Asian economies, are doing the same thing. However, since the end of 2006, the monetary consequences of reserve accumulation were obviously becoming difficult to bear; the RBI had to make a trade-off between fighting inflation and preserving the exchange rate.
It is time we started to think in terms of a steady appreciation of the rupee in the longer term. There are several analytical questions that this raises. In this theme, we explore one of them, using the CRISIL Parameter of Competitiveness.
The conventional measure of export competitiveness is the real effective exchange rate published by the RBI. This is essentially a weighted average exchange rate of the rupee against other currencies adjusted by relative prices. There are however problems with these conventional measures. They assume that exports compete with the
domestic industry of buyers.
That is not usually the case -- in the main export product categories, India competes not with the buyers' domestic industry but with other exporters. Thus, the relevant gauges of competitiveness are the price changes and currency movements in other emerging economies whose exports compete with India. We address this issue through the PARC.
The index has two components:
The weighted average exchange rate of the rupee against the competitor's currencies. The weights are the shares of these countries' exports in world exports and reflect their market shares in the global market.
The average inflation differential between India and these competitors using the same set of weights.
The PARC combines these two elements, using the basic principle of purchasing power parity. If PPP holds every month, the depreciation in the currency would correct for the inflation differential and export competitiveness would remain unchanged. If the currency depreciates by more than the inflation differential, the currency is undervalued and if it depreciates by less (or appreciates), the rupee becomes overvalued. Of course, if the inflation differential is negative, PPP warrants exchange rate appreciation by that quantum.
The amount of overvaluation or undervaluation can be aggregated across months to give the cumulative undervaluation or overvaluation form a base period. This is the PARC index. While we periodically change the list of countries used to generate the PARC for India, the largest share of competing exports is from Asian countries, with some representation
from
Europe, Africa and Latin America.
The logic of the PARC indicates that the mere fact that the rupee has been appreciating against the major global currencies does not imply that India's export competitiveness has suffered. For this to happen, we would need to also see the rupee appreciating against the basket of currencies included in the PARC. Figure 1 displays the movements in the PARC and export performance since the beginning of 2006. The negative trend in the PARC indicates relative appreciation against the basket of currencies of competing countries and, therefore, a loss in competitiveness.
The pattern is unambiguous. The rupee has been appreciating against competitor currencies over the entire period. In the early part of the period, export growth continued to accelerate, but the figure shows that currency appreciation acts with a lag of a few months. By the middle of 2006, export growth began to decelerate and has maintained this trend in line with the PARC since then. There is little question that Indian exports are currently losing ground to competitors because of currency appreciation.
However, it is also important to point out that the appreciation reflected in the PARC is not all that recent a phenomenon. Figure 2 provides a somewhat longer history of movements in the PARC and export growth rates. It indicates that the current appreciation phase of PARC began as far back as the end of 2005. The recent, sharp movements of the rupee against the dollar, which have intensified concerns about the loss of competitiveness, may be reinforcing the trend, but they do not appear to have initiated it.
The patterns in Figure 2 also provide insights into the relative significance of currency movements versus other factors that determine export growth rates. The only comparable movement to the recent sharp decline in the PARC was in the early part of the period represented in the figure, in the opposite direction (an increase in competitiveness).
As in the recent episode, export growth responded strongly with a lag of a few months to this. As the changes in the PARC levelled off, albeit with a general trend towards increasing competitiveness, the growth rate of exports became more volatile and clearly less correlated with currency movements. Other factors obviously began to dominate the
effects of exchange rate movements during this period.
Thus, during 2003 and 2004, while there was hardly any change in the PARC, there was both a sharp deceleration in export growth and a sharp recovery. Again, during the year or so before the most recent trend manifested itself, the PARC was relatively stable, indicating a neutral currency environment, but export growth once again declined and
recovered during the period, before settling into the deceleration phase over the last year.
The broad inference that emerges from the analysis of the PARC and export growth rates during this period is that sharp movements in the PARC do cause sharp accelerations or decelerations in exports. However, when the currency has stabilised so that it moves in a narrow band with respect to competing currencies, there is no guarantee that export
growth will also similarly stabilise. As things stand, the upward movement of the rupee appears to be much sharper than that of currencies in competing countries, many of which are also experiencing similar surpluses in their balance of payments.
The authors are Economist and Chief Economist, respectively, at CRISIL