Making Sense of the Rupee

Many decades ago, private capital flows across countries were miniscule. The standard story which was played out in the balance of payments ran like this: exports and imports would take place, and the trade deficit (if any) would be typically compensated by the foreign aid coming into the country in the form of concessional, long-term credit.

India was then fairly closed to the world on the capital account. Exchange rates were mainly driven by trade flows. On the foreign exchange market, exporters would sell dollars to buy rupees, and importers would do the reverse. If a true market were allowed to operate on the exchange rate, the supply and demand for rupees by these importers and exporters would determine the price of the rupee.

The idea of the real effective exchange rate (REER) had significant usefulness in such a world, in trying to make sense of exchange rates. If prices in India rose by more than the inflation rates seen among India's trading partners, then it was only fair that the rupee should depreciate, otherwise the trade deficit would widen through increased imports and decreased exports.

The REER is an approximation, to be sure, for changes in trade competitiveness are not purely driven by prices changes. For example, India's software industry has obtained huge growth in exports through skills development which would not have been predicted by a pure focus upon relative inflation rates alone. Over long time-periods, changes to protectionism, skills and infrastructure have a major impact upon exports and imports. However, if the time-horizons are short, then changes in the REER are useful in forecasting changes in the current account balance. Hence if exchange rate determination was primarily about trade-related flows, then the REER would be quite useful in making sense of exchange rate changes.

The usefulness of this conceptual framework is drastically diminished in the world that we now live in.

The major change which has taken place is the rise of large capital flows. There is a pronounced recognition today of the low rates of return on investment in capital-rich countries (like the OECD countries, where real interest rates are typically below 2%) and the high rates of return on investment in capital-scarce countries (like India, where real interest rates are typically above 5%). This has been accompanied by improvements in legal and institutional arrangements which are conducive to international capital flows. Hence high interest rates in India, coupled with the risk reduction obtained through diversification when a foreign investor comes into India, have brought about large capital inflows to the country.

This transforms the picture on the foreign exchange market. The dollar-rupee market now reflects (a) exporters trying to buy rupees, (b) importers trying to sell rupees and (c) foreign investors (both FDI and FII) trying to buy rupees. This is bound to lead to a substantially different exchange rate as compared with a world without capital flows. For those focussed upon the trade account alone, it will inevitably appear that the rupee is overvalued - e.g. the slow growth of exports which is now being felt in India. However, that is an incomplete picture of the situation.

It is useful to take one fact of the balance of payments very seriously: the net foreign savings into the country are equal to the current account deficit. This statement is an accounting identity which must always hold. Intuitively, it may be comfortable to think of Indian bonds and shares leaving the country and returning in the form of VCRs and machine tools. The basic fact highlighted here is that the inflow of foreign savings into India is equal and opposite to the current account deficit. Foreign savings cannot come into India without a concomitant current account deficit.

This has serious implications in a world with capital inflows. The stated purpose of capital inflows is to augment domestic savings and help spur growth through greater investment. The accounting identity above suggests that an enlargement of foreign savings can only come with an enlargement of the current account deficit - i.e. an overvalued rupee this hurts exports and spurs growth of imports.

One policy intervention which is often proposed, and has been often used by the Reserve Bank, consists of directly intervening in the market to buy dollars. This is fairly uncomfortable in an economic policy framework where markets, and not governments, should determine prices. For economists who study financial markets, the notion of a government doing market operations on the currency market is about as appealing as the prospect of a government doing market operations on the stock market.

When the RBI intervenes to buy dollars, it is artificially generating an undervalued rupees. It is "helping exporters", shrinking the current account deficit, and effectively denying a larger role for foreign savings in the economy. In addition, the sale of rupees typically increases the money stock in the economy which has inflationary consequences in the weeks and months that follow.

This yields a paradoxical situation. Some parts of economic policymaking are working hard to increase inflows of capital into the country. At the same time, the Reserve Bank is working towards diminishing the size of net inflows of foreign savings into the economy.

In such a world, there is a limited usefulness in the REER. The REER does have value in understanding year-to-year movements on the trade flows; however, there is much more to making sense of the exchange rate than just trade flows.

What would be the consequence of REER targeting on the part of the RBI? If, from one year to the next, the RBI tries to hold the REER constant, then it would be trying to counter the effects of the change in capital flows. To the extent that capital inflows grow, the RBI would have to steadily defend the rupee. This would have the consequence of raising money supply and helping exporters.

The diminished role for trade flows, and hence for the REER, in international finance is part of a larger phenomenon: the transformation of currencies into financial instruments. The modern understanding of currency markets is based upon a financial economics notion of risk and return. The price of the dollar is that level at which the risk and return obtained by being long dollars today is a "fair" risk-return tradeoff, as compared with that found with all other currencies.

The finance approach sees a healthy role for speculators to rapidly communicate information about future risk and return into the market. This is in sharp contrast with a focus on trade flows, where exchange rate volatility is viewed with incomprehension and suspicion.

This approach is consistent with the fact that the vast fraction of transactions on the international currency markets have nothing to do with either imports or exports. There is undoubtedly a flow of orders coming into the currency markets from non-speculative importers or exporters who have perforce got to use these markets. However, these orders are about as important for price discovery as the orders which come into a stock market from people selling shares to finance a marriage in the family or people accumulating savings and then buying shares. The real brunt of price discovery takes place through `informed traders', i.e. speculators and professional traders who work on absorbing news and information to assess future risk and return.

Back up to Ajay Shah's media page