Is the Rupee undervalued?

Votaries of a weak rupee point to the example of China which – to the rest of the world’s annoyance – has deliberately kept the yuan undervalued, forcing US legislators to consider officially declaring Beijing a ‘currency manipulator’. The comparison with India though is not valid. China is the manufacturing workshop of the world. Exports comprise around 32% of its GDP. Last year, it displaced Germany as the world’s largest exporter (with annual exports of $2 trillion). In contrast, exports account for only 18% of India’s GDP. A weak rupee does not help the other 82% of India’s economy. Quite the contrary: a current account deficit arising from an import bill of $460 billion (over 25% of Indian GDP) erodes the currency, pushes up inflation and lowers competitiveness.

A stronger rupee will not only trim India’s  trade and current account deficits and temper inflation, it will attract more FDI and FII. Today, foreign investors factor in a historical 4% annual depreciation of the rupee when computing their return on investment. Were the rupee to strengthen, dollar returns would rise concomitantly. Average central bank lending rates in the west and Japan are 0.25-3%. In India, the RBI’s repo rate, at which it lends funds to banks, has averaged 7.00-8.50% in the recent past. The gap mirrors precisely the historical annual depreciation of the rupee against the dollar. A stronger rupee would reduce that gap and bring India in line with advanced economies.

Wouldn’t Indian services – especially IT software – suffer if the rupee hardens? Service exports sell increasingly on quality, not price. Many (especially refined petroproducts and polished diamonds) have high import content. Besides, services include sectors such as foreign tourism that benefit from a stronger rupee. The biggest long-term beneficiaries of a stronger rupee would be India’s manufacturing productivity.

Cheaper imports would allow companies to ramp up foreign technology and build infrastructural and manufacturing assets. These, in turn, would lead to a spike in competitiveness, boosting exports based on quality, not marked-down prices. This would create a virtuous cycle of high productivity and quality allied with low inflation and deficits.

So what should be the value of a more muscular rupee? The Economist’s latest Big Mac Index shows that the rupee is undervalued vis-A -vis the US dollar by 61% while the yuan is undervalued by 41%. While The Economist’s Big Mac Index has, over the years, been a surprisingly accurate indicator of exchange rate trends, discounting The Economist’s index for India’s low-cost economy, the rupee is probably currently undervalued against the dollar by about 25%. A fair value of the rupee would, therefore, be just under 40 to a dollar. Our former finance minister, now prime minister, who 20 years ago said 25 to a dollar was fair value for the rupee in pre-reform India, might well agree.

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