One wonders what level of REER would give comfort to the central bank.
In the midst of a trade war that has already unnerved global investors, is a currency war taking root? The rupee’s steady slide and the stoic approach of the central bank spark that thought. But will it help India’s competitive positioning and outweigh the negatives that accompany a steep currency depreciation?
Our analysis of currency movements of major emerging economies suggests that while country-specific factors had their impact on currency behaviour between July 2017 and June 2018, the recent fall appears a lot more in concert.
In that period, the Indian currency depreciated by close to 6 percent, making it a modest performer amongst its peer group as some countries experienced huge falls due to their own specific factors.
Have we depreciated enough?
In real effective exchange rate (REER) terms, our decline has been less; therefore if we consider currency as a source of competitiveness, our positioning might have worsened.
The real effective exchange rate is defined as “a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries”. REER takes price differences and inflation into account and, therefore, is said to be a better indicator of the competitiveness of the country in terms of exchange rates.
In India, RBI complies REER indices, which are a better reflection of the position of a currency vis-a-vis countries with which we have large export and trading relationships. A rise in the level of the index indicates an appreciation of the currency and vice-versa.
Source: RBI, Reuters
In the period under review, the decline in India’s REER has been modest, to the tune of 3.9 percent. Some of our competitors have seen a better realignment of their respective REER, like Indonesia and Russia.
However, despite the currency not being overtly supportive, in FY18 India’s external sector exhibited resilience in the face of firmer international crude prices and domestic supply constraints. Export performance improved, although a sharp rise in imports expanded the trade deficit to a five-year high. Despite support from net invisibles, the current account deficit (CAD) widened.
Responding to a volatile and hostile global environment
But crude is just one imponderable.
While last year saw the international environment improving with global trade outpacing global growth and capital flows to emerging economies rebounding, the subsequent intensification of trade protectionism and retaliatory strategies have left their scars. These developments have put a question mark on trade as a growth engine. Global financial markets have been re-pricing the normalisation of monetary policy by central banks which, in turn, has resulted in sell-offs in financial markets, realignment of major currencies and a considerable flux in capital flows.
Seen in this light, the latest bout of currency volatility looks like a part of a global phenomenon as most competitor currencies have charted a similar trajectory. So is it beginning of a currency war?
A currency war or competitive devaluation refers to a situation where a number of nations seek to deliberately depreciate the value of their currencies in order to stimulate their economies.
But India has never been in the group of countries charting the path of export to grow. In fact, RBI has admitted that our exports- to-GDP has been persistently declining. In contrast to global developments, where income elasticity of exports has improved, the income elasticity of India’s exports has remained broadly stagnant, suggesting that the response of India’s export to global growth has been limited. India’s exports have faced erosion in terms of market presence. Consequently, the share of India’s exports in world exports has been constant at around 1.7 per cent in the last five years, possibly pointing to a protracted stagnation in competitiveness.
So the competitive devaluation is unlikely to correct our current account deficit by giving a boost to exports in such uncertain times. Given that RBI has a very comfortable foreign exchange reserve position, the silence is surprising and makes one wonder what level of REER would give comfort to the central bank.In the near term, the rising crude and the falling rupee is a perfect recipe for another round of interest rate increases, and markets had better brace themselves.