Is the Rupee fairly valued? RBI's new CPI based REER has a story to tell

April 25, 2014

RBI Watch                                                                                                     Indian Rupee

The RBI in its current Monthly Bulletin April 2014 has computed Real Effective Exchange Rate (REER) using CPI (Consumer Price Inflation) for computation of REER from 2004-05. Going ahead RBI will publish REER using CPI. This makes sense because RBI is now monitoring CPI not WPI for deciding its course of monetary policy. Just as importantly, using WPI for home prices and CPI for overseas prices is somewhat like comparing apples and oranges in the computation of REER.

RBI has shown NEER (Nominal Effective Exchange Rate) numbers in a separate spreadsheet accompanying the Monthly Bulletin.

RBI’s paper highlights that REER data based on the WPI and CPI show divergent trends. This was expected as over the last few years CPI has accelerated at a faster pace than WPI in India.

The RBI CPI REER series uses 2004-05 as base. In 20004-5 the current account deficit was close to balance. Arguably, the rupee was then by and large in equilibrium.

Now, an important point from the RBI data is that as of March, 2014, the rupee cannot be considered to be undervalued - it has risen by 4% (REER: 104 but down from the 2011 peak of 116) on a 36 currency trade weighted basis, and it has risen by 11% (REER: 111 but down from the 2011 peak of 128) on a 6 currency trade weighted index - the major currencies used for trade with India. (Note the REER WPI picture is misleading: it shows that the rupee has fallen.)

How does one explain this when the rupee depreciated sharply during the last few years? For example, it stands now at about Rs 61 against the Dollar after being Rs 50 five years ago. Using an index, NEER – the nominal exchange value of the rupee against a basket of currencies - shows that the rupee has fallen significantly compared to the base year 2004-05.

This is nominal depreciation of the rupee. But prices in India, especially consumer prices have trended up in the last five years, while prices abroad, e.g. our major trading partners, have trended up but by less. Both the US and the Euro areas are worried about deflation and hence the ultra-loose monetary policy of the Federal Reserve and the ECB, while in In India we are worried about inflation and hence the tight monetary policy stance of the RBI.

To know what has happened to the rupee we need to compute the rupee exchange rate in real terms – after adjusting for the movement in prices in India as compared to movement in prices in abroad. This explains the use of REER as a better indicator of what has happened to the rupee and the CPI REER results as indicated above.

What the REER numbers show is that going ahead for REER to come closer to 100 – where the rupee is considered to be fairly valued - inflation in India will need to moderate relative to our major trading partners and/or the rupee will need to fall further against its major trading partners, e.g. the US dollar.

Yet, it is quite likely that if there is a favourable and significant verdict in the General Elections currently underway in favour of the Congress or the BJP (especially so in the case of BJP, as it appears from press reports), the rupee may appreciate significantly from current levels as foreigners show greater demand for Indian assets The RBI may then need to step in and buy dollars to prevent further appreciation of the rupee, thereby keeping the rupee competitive for trade purposes.

This is, of course, assuming ceteris paribus!

If you are one looking to trade in Indian assets or have trade related exposure to the Indian rupee or trade the rupee on the currency futures exchange, it would be worthwhile to keep a watch on RBI’s new CPI based REER data.