The RBI measures real effective exchange rate wrongly since it ignores third-country rates

If wishes were horses, India’s commerce ministers would ride them. That could be one reason why the new medium term export strategy unveiled last week aims at achieving a one percent share of world trade for India over the next five years.

The proposed strategy is old as the hills: focus on key markets and products and to give a greater thrust to the export of agro-based products. Efforts are also going to be made, the minister said, to cut tariffs and to bring existing export promotion schemes in line with the WTO rules.

One of the key elements of the strategy is going to be to maintain the REER of the rupee at a “level appropriate for ensuring price competitiveness of exports”. The minister argued for a cheaper rupee, pointing out that the extent of rupee depreciation has not been to the level of India’s competitors in South East Asia. It is nice to know that this point has finally got across, at least to some in the government.

Unfortunately, however, Mr Maran has as much control over the exchange rate as the prime minister does over the ram sevaks. Worse, the RBI, which manages the exchange rate, regardless of how “market determined” it is, seems to be happy with the current level of the rupee.

But Mr Maran does have a point. At a time when Indian exports are losing market share, exchange rate policy should be supportive and not undermine the competitiveness of Indian exports. To offset the large number of structural constraints such as roads, shipping and other infrastructural problems, power shortages, labour laws, etc that push up costs in India relative to its competitors, at least the rupee’s value should be kept in line with the depreciation in their currencies.

And, since subsidising exports will be more and more difficult in any form under the WTO rules, until the time when reforms have taken place and costs reduced, a careful eye must be kept on the rupee to prevent any real appreciation.

Strangely enough, incomprehensible as it sounds, the government has played an active role in keeping the rupee from weakening and has thus helped in eroding the competitiveness of Indian exports. Perhaps, it was simply a lack of understanding that capital inflows would push up the rupee. Perhaps, as some people have suggested, it was a political move to benefit the NRI community.

But whatever its intentions, when the government floated the Millennium India Bonds it did exports a great disservice. Not only were they costly in terms of the rates of interest, they contributed significantly in keeping the rupee strong. So even before repayment of the bonds becomes due, the country is already paying the price for them.

Apart from perhaps a misplaced sense of national pride, the fact that the rupee has been allowed to appreciate also has to do with not getting our facts right. It is often argued that the real exchange rate has not appreciated. The data depends, first, on the base year chosen. But even if an ‘appropriate’ base year is chosen, it depends on the way the RBI measures the REER.

For the purpose of analysing the competitiveness of our exports it is important that the measure should capture exchange rate movements of the currencies of competing countries. Because if it does not, then exports will be losing competitiveness even when the REER is not seen to be appreciating. In the Indian case it is likely that this is happening.

So how does the RBI construct the REER? The real exchange rate is defined as the nominal exchange rate adjusted by domestic local-currency prices relative to foreign local-currency prices. The indices are constructed based on bilateral export weights and bilateral total trade (exports plus imports) weights. These are five-country, 10-country and 36-country indices.

In the construction of these indices is the implicit assumption that “from the buyer’s point of view, the elasticity of substitution as between the sources of supply is zero” (RBI). In other words, domestic producers are the only competitors for Indian exports and competition from third country exporters does not exist.

In contrast, real effective exchange rates for industrialised countries constructed by the IMF take into account each country’s trade with its partner and competitor countries. The weights reflect both the relative importance of a country’s trading partners in its direct bilateral trade relations and that resulting from competition in third markets.

To overcome the limitation in India’s measure of the REER, multilateral weights need to be constructed to take into account the importance of third-country competitors as well as domestic producers in various markets for India’s exports.

The RBI Bulletin, July 1993 noted that this could be regarded as a second stage of the exercise of construction of effective exchange rates and that the indices it publishes may be regarded as approximation of the underlying price/cost competitiveness of India’s exports.

Since the REER does not capture competitor country currencies, it is not surprising that there is a lack of ‘evidence’ to support the role of the exchange rate in determining India’s exports. By ‘evidence’ I mean econometric support that, unfortunately, has become one of the most misused tools in economics. Despite recognition of its atheoretic nature, it often takes precedence over economic theory. A look at the ‘evidence’ in this case shows us how wrong we can go.

It appears, for instance, that econometric results on the relation between exports and the real exchange rate in India shows that the REER does not have a ‘significant’ impact on the quantum of India’s exports (Research and Information System, DP-13). This would be fine if there were no competing sources of supply for importing countries.

But this is not the case and the importing country can purchase from a third country if it depreciates its currency and thus reduces the dollar price of its exports. But as this does not show up in our measure of the exchange rate, we come to the erroneous conclusion that exchange rates don’t matter!

If India is to increase its share of exports in world trade from 0.67 per cent at present to 1 per cent, over the next five years, exports are required to grow at an annual rate of 12 per cent to achieve this target. Clearly, there is a role for an exchange rate policy that helps, and not hinders, the competitiveness of India’s exports.

My hunch is that if we were looking at the right measure of the real exchange rate we need not be complacent that the rupee is at its appropriate level. The case for a weaker rupee may then be clearer. And maybe then the RBI could engineer the desired depreciation.

(The author is a Senior Fellow at ICRIER. These are her personal views)