Rupee’s Overvaluation In Focus As Yuan Falls To 6-Year Low

Rupee at its most overvalued based on real effective exchange rate index

Indian rupee (Photographer: Scott Eells/Bloomberg)
Indian rupee (Photographer: Scott Eells/Bloomberg)

A recent fall in the Chinese currency, which slid to a six-year low on Thursday, brings the Indian currency’s own valuation back in focus.

Data released by the Reserve Bank of India (RBI) on Monday showed that the Indian rupee is more overvalued than it has ever been on a real effective exchange rate basis. The 36-country trade weighted real effective exchange rate (REER) index was at 114.51 at the end of September, according to the RBI’s monthly bulletin. This is higher than 113.87 at the end of August and 112.06 at the end of September last year.

The 36-country REER benchmarks the value of the Indian currency against its trading partners. An index level of 100 would reflect a fairly valued currency. Since India is a net importer, the RBI typically prefers the currency to be slightly overvalued in the range of 105-106.

The REER index, however, has remained well above that for sometime now. In fact, data available on Bloomberg shows that the index is at the highest level since 2004, suggesting that the rupee remains considerably overvalued.

36-Country Trade Weighted REER
36-Country Trade Weighted REER

Concerns that this overvaluation of the Indian rupee is hurting exports has pushed the commerce ministry to call for a weaker currency. On September 12, The Indian Express reported that the commerce ministry is seeking an “institutional mechanism” to determine the right value of the rupee. This led to rumours of a move to devalue the rupee, which were later denied by the government.

Still, currency market veterans say there is a case to depreciate the rupee. In a note released on Wednesday, Jamal Mecklai, chief executive office of Mecklai Financial noted that while talk of a devaluation may seem like “nonsense” since the rupee is not a controlled currency, a call for a weaker currency is economically justified.

While weak global demand may be the underlying reason for sluggish exports, Mecklai says the relative strength of the currency is adding to the pain of exporters in the manufacturing sector, in particular.

During the April-August period, exports have dipped by 0.5 percent to $96.98 billion. Exports contracted nearly 16 percent in fiscal 2016.

RBI should buy dollars ever more aggressively to push the rupee closer to a level (say, north of 68) that supports growth. If/when that move gets exacerbated by global events, RBI can respond by selling dollars to calm things down, as it has many times before.  
Jamal Mecklai, CEO, Mecklai Financial

Yuan, Rupee Diverge

The rupee’s performance has also diverged from the Chinese currency in recent months. While the Chinese Yuan has steadily depreciated since August 2015 when the currency was first devalued, the Indian rupee has moved in a band.

Since 10 August 2015, when China devalued its currency, the Yuan has fallen by close to 8.3 percent. The rupee has fallen a much lower 4.7 percent, denting the Indian’s currency’s competitiveness vis-a-vis the Chinese currency.

Rupee’s Overvaluation In Focus As Yuan Falls To 6-Year Low

As the chart above shows, the divergence between the yuan and the rupee has only widened over the past two months. On Thursday, the Chinese currency fell to a six-year low below 6.7 against the U.S. dollar. The rupee also weakened in response to a stronger dollar and fell to 66.93 against the U.S. currency.

The latest bout of weakness in the yuan is being driven by weak trade data and falling foreign exchange reserves. Chinese exports fell more than the expected 10 percent in September. Last week, government data showed that foreign exchange reserves in China fell to the lowest levels in five years.

In India, while exports remain weak, the pace of decline has eased in recent months. Foreign exchange reserves, meantime, are at an all-time high of $372 billion. India has also being getting a steady stream of portfolio flows. Year-to-date, foreign investors have bought $7.76 billion in equity and sold about $453 million in debt.

The RBI has absorbed most of these inflows in preparation for the redemption of foreign currency non-resident deposits raised in 2013 and to ensure the currency doesn’t get excessively overvalued. They may have to continue doing that and should also look at absorbing additional flows for a managed depreciation of the currency, said Samir Lodha, managing director at QuantArt Market Solutions, a forex consultancy firm.

With the depreciation in the yuan, the REER index will move up further next month. A fall in the yuan will impact both exporters and domestic industry as imports from China will become cheaper and more cost effective.
Samir Lodha, Managing Director, QuantArt Market Solutions