Monday, August 12, 2013

We don't know much about what the exchange rate ought to be

Many people are confidently saying that the market's price of the rupee-dollar exchange rate is wrong. They think they know what the exchange rate should be. There are many pitfalls along this path.

The simplest international trade perspective

To fix intuition, let's think there are only two countries: India and the US. Suppose there was no capital account. Suppose there was only import and export of goods and services on the current account. In the absence of a capital account, in every time period, the current account would have to work out to zero. The currency market would clear to yield an appropriate exchange rate from the viewpoint of export competitiveness. We would find an exchange rate at which we earn enough export proceeds to be able to pay for for our imports (that are also a function of this exchange rate).

Suppose we had a base year in which things were square. Now, from that point onwards, one could look at inflation in the two countries and the exchange rate and get a sense about how export competitiveness was changing. As an example, inflation in India is 10% and inflation in the US is 2% so we might think that the exchange rate should depreciate steadily at 8% per year in order to keep the CAD at 0.

The Real Effective Exchange Rate (REER) goes one step further and implements this calculation while taking into account the fact that India trades with many countries. A note of caution: The best REER measure for India is that made by the BIS.

Problem 1: The export basket is different from the CPI

The CPI is, indeed, the best measure of inflation. But the things that we export and import are not the things that the average household consumes. Hence, this crude estimate -- that the rupee should depreciate by roughly 8 per cent per year on average -- is wrong.

There is really no way to solve this problem. In an ideal world, we would have price indexes that are specific to the import and export basket. But these indexes are essentially impossible to make. Think of all the goods and services that India imports or exports, and the problems of obtaining a sensible price for each of them.

Problem 2: Productivity is not constant

All this assumes that nothing else is changing. But productivity is changing, slowly in the US and dramatically in India. In our backyard, there are a million microeconomic mutinies, through which production is becoming more efficient. Individuals learn. Firms improve their processes. Indian firms get internationalised, and global firms start operating here, all of which drives a ferment of improving knowledge. Our indirect tax policy & administration has slowly gotten better. State of the art equipment gets brought in. We learn how to utilise better and more specialised raw materials (which are often imported). Infrastructure gets better, thus linking up productive capacity in difficult locations (e.g. 100 km away from Bombay, 1000 km away from Bombay, 4000 km away from Bombay) to global markets.

The pair of graphs here is blindingly obvious and yet revealing. From 1994 till 2010, the Indian REER fluctuated between 85 and 110. Over this period, merchandise exports grew from \$2 billion a month to \$15 billion a month. What was going on? Superior Indian productivity growth.

Qingyuan Du, Shang-Jin Wei and Peichu Xie have a fascinating new paper Roads and the real exchange rate, which finds that changes in transport infrastructure have important implications for the real exchange rate.

Problem 3: The exchange rate is actually mostly about finance and not trade

So far, we have played in the simplest world where there was no capital account, and all that was going on was imports and exports (of goods and services). That's not the world that we live in anymore. We have a mostly open capital account, which gives each country the convenience of not having to achieve a CAD of 0 in every time period. We obtain microeconomic gains from international capital flows.

In 2012-13, India had inflows on the current account of \$452 billion and outflows of \$583 billion. If this was all that was going on, on the currency market, we would have trading volume of \$583 billion per year. The outflows would require buying \$583 billion. On the other side would be exporters selling \$452 billion and capital inflows filling the gap. This translates to (one way) turnover on the currency market of \$2.3 billion per day. In truth, the currency market for the rupee trades between \$40 billion and \$70 billion every day. The overall activity on the currency market dwarfs the minor business of sorting out the current account. The currency is now a financial product.

Bottom line: Exchange rate assessment is a mugs game

We started out with a simple and intuitive world, but ran into three problems. We can't quite use CPI in India and in trading partners, as the CPI is the basket consumed by the household and not a reflection of prices of the goods and services that are traded. The big story is all about productivity growth in India, which we know little about. And, the exchange rate is a financial object and not driven in the short run or medium term by trade considerations.

Policy makers should be cautious when thinking there is something going wrong with the market's exchange rate

When so little is known about exchange rate assessment, we should be cautious before determining that something is wrong with the exchange rate that the currency market has made.

None of this is new (1997, 2007). But every few years, we seem to come up against a situation where policy makers have strong views on what the exchange rate ought to be. We may all have our own personal opinions about what the exchange rate ought to be. A Hippocratic oath should prevent us from undertaking interventions in the real world that have manifestly visible costs [link, link], until we are really sure that there are corresponding gains.


  1. Ajay, thanks for a great article. Is it that policy makers are guessing what the right exchange rate should be (a frightening prospect), or is it that they need to smoothen the transition to whatever the right market-determined rate is. The latter seems more like the concern here, because sharp volatility can create long term consequences, without time to adjust to the change...

  2. While not directly relating to the subject of 'measuring an exchange rate', i see INR again weaker after the FM announces measures that includes issuance of quasi-sovereign bonds to be raised by PSU FinCos plus some likely relaxation on the ECBs.

    Will it not be a better idea to pay, say 4% for 3 years, for all FCNR deposits - any PSU that would raise a 3-5 year bond will end up paying 300-350 basis over midswap.. Rather than adding that way to the external debt (when RBI already has a 280b reserves), it would be more useful if the NRI gets that benefit. A lock-in period or some attractive frills can be embedded so that the NRI sees value. An NRI will also close loans taken for the purpose of remittances - out of his earnings - which will help a non-disruptive process of closing out the liability (opposed to a PSU loan where halfyearly repayments will create sufficient noise in the onshore markets).

    A run-down in gold reserves by say 5b will also help but it may have other ramifications internationally..

    Why not the government invite prize-winning suggestions on how to tackle this currency crisis? Rather than leaving it to the panelists in prime channels (who range from agricultural ministers to film-personalities turned MPs to ever-pessimistic opposition leader, and as if this is not enough, a terrible moderator among them from the channel), it would be better to hold intelligent debates and discussions that pave a way for managing this crisis.

    The worst is yet not over - a possible downgrade by major rating agencies (say the foodbill passage and its impact on the fiscals) is likely to make matters worse for the PSUs or whoever is likely to raise FC debt.

    1. "Why not the government invite prize-winning suggestions on how to tackle this currency crisis?"

      Did you even read the article? The admin should stop focusing on just relieving the symptom and focus on the real problem. The currency will be strong only if the economy is strong. Period. There is nothing else to be done to manage the volatility or direction or whatever. Focus on the fundamentals of the economy.

      Secondly, what needs to be done is common sense. No need for prize winning suggestions. Its not rocket science.

    2. One more point. Lets talk about how we got into the currency crisis situation and make sure we don't do that again. In other words, while we are all talking about how to fix this currency crisis, why don't we focus on the actual problem of how we got here? Why is the media and intelligentsia not asking the govt about this? Why is the govt allowed to behave like this currency crisis is some exogenous phenomenon that occurred independent of its disastrous policies. Lets talk about how we got here, shall we?

    3. Agreed, Mr/Miss/Mrs Anonymous.
      Do you have a suggestion or suggestions to offer?
      i don't have any, honestly.
      There is none actually that will work wonders overnight.
      Its becoming a cliche to hear 'focus on fundamentals and don't treat the symptoms'. If it was so clear at a macro level, someone as distinguished as Subbarao would have done differently from whatever we have seen in the last 3 months..
      Govt is afterall the same set of people that was earlier common ma(e)n Manmohan Singh is not someone who does not understand Central Banking nor is he new to currency crisis. And, if someone had known 'we will get into this currency crisis situation', probably he or she would not have pushed it either. I don't know but if it just common sense, we wouldnt be battling for weeks at a stretch..

    4. Huh? You seem to have missed the point and the article.

      What specific suggestion are you looking for? For the Droopee? Nothing needs to be done. What exactly are you hoping for? Didn't you read the article? For the CAD, again, nothing needs to be done (currency depreciation helps with that to some extent).

      And, we need to get out of this habit of short-termism and focus on fundamentals of domestic production and export sector, to make them more competitive by sound long term policies.

      And, you can just see what other non-establishment economists have been saying for the past 2-3 years to see that it is indeed commonsense as to what needs to be done. The threat of CAD crisis, capital flight, currency, inflation are not new problems. Just read what other economists have been saying in any of the newspapers, for quite some time now.

      Just because something is a cliche, doesn't make it wrong. The commonsense question is why have these cliched focus on fundamentals not been carried out for such a long period? Why do we expect or deserve any better when the fundamentals have not been looked after for so long?

      I find your comments on RBI and MMS amusing. Do you have any evidence of their expertise? The very fact that a) they are battling this for weeks, and b) in the most childish manner possible, is evidence to the contrary.

      Actually, there is an overnight fix for everything and it is coming up:

      Raghuram Rajan’s handsomeness averts India’s economic crisis

    5. I agree - non-establishment economists have indeed been warning. To a very large extent even the outgoing RBI Governor has been warning (and it requires courage to do so in the Indian bureaucratic setup). Not holding his brief just because of intimacy, but i would give him all credit for whatever has been done.

      i started my post with a caveat that my comments may not directly relate to the subject article so please understand i have read this wonderful piece and am in agreement. like many in INDIA, i am a great fan of Ajay Shah.

      i started a tangentially different string with a comment on the futility of these short term measures - which is what you also endorse.

      I know i cannot say US has a long history of CAD. USD enjoys the reserve currency status one might say and hence capital flows compensate. Australia has no less a different history. Current Account to GDP in Australia averaged -4.20 pct for 30 years from 1980, reaching record low of -6.20 pct in December of 2007. But that would also go down as a different league game. Unfortunately we are in the league of Turkey and South Africa.

      This argument can go on endlessly - and that is not my intention - i am not an economist - just a common (sensed) man..

      In many ways Bernanke and Subba Rao rode the roughest times of their respective economies - Let us hope the Rajans and Summers or Yellens of the world get the luck of the Carneys of the world..

      MMS's credentials are i thought on public domain - his background as an Oxford economist, his positions in UNCTAD, finance ministry, planning commission, his stellar role in early 1990s when the country had barely half a months fx reserves.. what more do we need. Maybe his folly was to abolish the licence raj at the instance of IMF - but that was a tradeoff for dough in the bowl we were holding.. Times are different and monetary policies have not been effective.. Central banks are growingly losing their independence and a total obfuscation will be the way forward

      Will be extremely happy if an overnight fix is coming and that is successful..

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