Enigma of undervalued rupee

Published: 20th August 2012 01:04 AM  |   Last Updated: 20th August 2012 01:04 AM   |  A+A-

As soon as we go abroad, we find that, almost all goods and services are much more expensive as compared to that in India. We immediately feel that India is one of cheaper place to live. This is mainly because on purchasing power parity, rupee’s actual value is much higher than it is reflected in the exchange rates.

Purchasing Power Parity (PPP) is a method for determining where the currency exchange rate ‘should’ be. The theory is that currency exchange rates between two countries should be at a level where goods can be purchased at the same price in either country. For example, if the price of an identical item is cheaper in Canada than in the United States, then the Canadian Dollar is considered undervalued and its value is likely to rise against the Dollar. One can find what should be the currency rate on the basis of PPP. Our rupee’s exchange rate has been much lower than its value on basis of PPP. We need to keep in mind that an undervalued currency is not guaranteed to rise. Currency valuations can be affected by many other factors, such as inflation, interest rates (Fisher Effect), constraints of trade, and the economic and political policies being followed by the country.

Based on the data published by the International Monetary Fund (IMF), we have data regarding relative valuation of various currencies as compared to the Dollar. There are countries that are in the red (currency having lower value than PPP) ie, the undervalued currencies. Similarly, there are countries that are in the green that have their currency as an overvalued currency as compared to the PPP. What is surprising is that most of the currencies in red are from the developing countries, while most of the currencies in the green are of developed world.

Amongst the developing countries, the Indian Rupee tops the list in being undervalued with a figure of -64.86 per cent. Other developing countries in the emerging markets are China with is undervalued at -33.42 per cent, Russian Ruble undervalued by -28.77 per cent and Mexico at -35.23 per cent.

Amongst the developed countries, we have almost all the currencies as overvalued. Norwegian Krone is overvalued by +76.3 per cent, the Swiss Franc overvalued by +71.98 per cent, the Australian Dollar overvalued by +38.21 per cent, New Zealand Dollar at +36.52 per cent and the Japanese Yen at +28.8 per cent.

We find from the above data that, on basis of PPP, the Indian Rupee is undervalued by 65 per cent. This is highest figure amongst the currencies of the developing countries and shows that rupee is one of most undervalued currencies in the world. In-spite of the undervalued currency our current account deficit is high and is putting further pressure on rupee to depreciate. This would make the rupee become further undervalued.

At times our economist feel happy at this depreciation of rupee, as they feel it would boost exports. However, this has not resulted in reduction of our current account deficit. It needs to be realised that, the exports do not depend upon the value of rupee alone. The factors affecting export are various. The major factors being, availability of exportable surplus, and availability of goods and services as per the quality standards required in the export market, and our marketing and political intelligence and push that we can muster. We are weak in all these counts and hence depreciation of rupee has not helped us to increase our exports dramatically. In fact with depreciation of rupee, the foreign buyers would negotiate further reduced prices in dollar terms for our goods and services, benefiting them further in getting our goods and services at an even lower cost. With lowered price realisation, our dollar inflow from exports may even drop. On the other hand, the import bill would balloon up and would result in further increase in the current account deficit, putting further pressure on rupee to depreciate.

Due to our currency being highly undervalued, foreign countries are able to buy our goods and services at rock bottom prices. Their cost of purchasing clothes, sugar, engineering items, iron ore, IT services, etc are lowered very much. This results in life of higher comfort for the developed world largely at our expense.

On the other hand, for developing countries, the cost of import of crude and high tech items escalates and results in high current account deficit, putting further pressure on currency to depreciate. India is a typical sufferer due to this phenomenon. Our crude oil bill which is at `5,00,000 crore/year, is resulting in high current account deficit. Due to our currency being undervalued, the cost of crude in terms of rupee per barrel is going up. The same is happening with the cost of import of edible oils, pulses and high tech items, for which India is a big importer. This escalated the cost of imports and becomes a driver for inflation.

We have to pay whatever prices are asked, for crude oil, defense equipment, fighter planes, and aircraft for civil aviation, chips and other high technology items. Besides, our research efforts are not directed to develop superior technologies in vital areas, resulting in our continuing dependence on imports for these items. Is the undervaluation of rupee a chance factor or that it is because of the political and economic policies being followed in India?

Possibly we have not followed long-term policies to contain the current account deficit. Our development model has been concentrating more on personal mode of transport, rather than putting in large investments for improvement of the public transport system and road infrastructure. We have also not given enough push to shift to gas for the transport industry, even though, the cost of gas is much lower as compared to crude oil for the same amount of energy content, besides being more environmentally friendly.

I wish to introduce a new concept here. The degree of undervaluation of a nation’s currency is a measure of success of its economic and political policies being pursued. Thus, at current undervaluation of rupee at -65 per cent on PPP, the performance of our economic and political policies is -65 per cent. Our economic and political policies, has not resulted in reduction in the undervaluation of rupee. By not being able to reduce the extent of undervaluation of rupee, we are committing crime against our own people as this would result in continuing of the lower standard of living for our people, high level of inflation and economic hardship.

Our every economic and political policy therefore needs to be directed to address this undervaluation of rupee on the PPP basis. The current situation poses a big challenge to formulators of our political and economic policies. Every policy initiative needs to be measured for its efficacy in reducing the undervaluation of rupee.

K K Jain is a professor at IBS, Mumbai.



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