Since October of last year the euro has slumped almost 20 percent versus the dollar as expectations of monetary tightening in the United States and loosening by the European Central Bank (ECB) have taken hold. In the past a strong dollar and rising US interest rates have been associated with emerging-market currency crises. The collapse of the Russian ruble, Nigerian naira, and Ukrainian hryvnia could be explained away by the collapse in oil prices and geopolitical tensions, but the emerging-market currency weakness is broad based. Versus the dollar the Brazilian real is down 28 percent, and the Indonesian rupiah, despite being cosseted by long-term gas contracts with Japan, has lost 8.3 percent. Even the Chinese renminbi is at risk of popping out of its tight fluctuation band on the side of weakness. The Indian rupee is alone in bucking that trend.
Since October 2013, the rupee has hardly budged against a rampaging dollar, and were it not for fear of intervention by the Reserve Bank of India (RBI), it might have appreciated. Is this unusual situation temporary, based around the euphoria of the new government of Prime Minister Narendra Modi? Or is a more fundamental revaluation taking place, one that would complicate the choices of policymakers normally concerned that an appreciating rupee would hurt exports and produce a surge in imports?
The current value of the rupee is around 68 rupees per dollar. But according to the International Monetary Fund (IMF), if you were to take a common basket of goods, the exchange rate that would make that basket equivalent in price in India and abroad is only18.5 rupees per dollar. On this purchasing-power-parity (PPP) basis the rupee is undervalued by more than 70 percent, more than any major currency other than the ruble.
Normally one would expect a country with such an undervalued currency on a PPP basis to be running a trade surplus as its exports are cheap and imports expensive. Yet India has been running endemic trade deficits not surpluses. According to the Reserve Bank of India, the trade deficit for 2013–14 was $136.1 billion.
There are two possible explanations for the missing surpluses. The first is that estimates of PPP are just wrong. PPP is an easy concept to understand but hard to compute. People in different countries, with different income levels, demographic structures, traditions, and tastes do not consume the same basket of goods, and so it is often not available for a fair comparison. It is striking therefore that other PPP studies come up with similar results.
Perhaps the most well known of these is the Economist magazine's light-hearted BigMac Index. The idea behind this index is to find a product that is identical in all respects, yet sold abundantly in different places, and then calculate the exchange rates that would make the price of this identical product the same across the world. In India they use a McDonald's Chicken Burger for comparison. According to the Economist, this sells for $4.79 in the United States and 116.25 rupees in India, making the "BigMac" PPP dollar-to-rupee rate equal to just 24.3 rupees per dollar, close to the IMF's PPP estimate and far from the current rate.
The second explanation for the missing surplus is that the difference between the current exchange rate and the PPP rate reflects India's poor nonprice competitiveness. It is a measure of the prize available if the new government were to use its mandate to dismantle the myriad of interventions in the price mechanism and administrative obstacles to making things in India.
An example is India's energy subsidies that lead to poor energy efficiency and excessive oil imports. Despite low meat consumption per capita—which is highly energy intensive—India consumes 17,485 BTUs per unit of GDP (source: US Energy Information Agency), almost twice as much as the world average and five times as much as in rich countries where energy use is heavily taxed, like the United Kingdom. Replacing subsidies with income support where necessary will lead to greater energy conservation, lower oil imports, and a better trade position. Before the collapse in prices, oil accounted for 40 percent of India's import bill. Small steps have already been taken in this direction, with the cover of lower oil prices allowing the government to take giant strides.
The recent budget signaled a shift to replace price-support mechanisms generally with income support. This switch will lead to a substitution away from currently subsidized food and fertilizer imports towards nontradeables. Changing the way welfare is delivered will be greatly helped by ancillary efforts such as rolling out the unique identity (UID) biometric database, passing on more distribution of welfare to innovative states away from central government and banking the unbanked. The latter, coupled with attempts to persuade gold investors to buy gold-linked financial contracts rather than physical gold, will also improve the trade figures. Gold can account for as much as 15 percent of India's imports during times of inflation uncertainty.
Lower gold imports would be a nice bonus, but bread-and-butter competitiveness issues are about removing price distortions and obstacles to business. We have a measure of how much this is worth to the exchange rate. If the Indian government implements half of what it needs to do, the rupee could continue to buck the trend of weaker emerging-market currencies. Moreover, the fundamental reasons for this strength should allow the RBI to take a more relaxed attitude to currency appreciation.