Opinion In currency,the rupee

But not so fast. Every important central bank in the world — including the very rich central banks of the US,China,Europe,Japan and Switzerland — has intervened at one time or another to either prevent its currency from appreciating or to prevent it from depreciating. And the reason they have intervened is because the central bank authorities felt,and felt very strongly,that the market has overshot. So while the refrain is that the market for currencies is like any other,say a fish market,the reality is that it is not. But if not,how can one determine the “fair” or “equilibrium” value of a currency? Since the term “fair value” will be used often,let me define it at the outset. The value is not known,but it is where markets should gravitate towards over a period of time,and most often do gravitate.

An estimate of fair currency value is an important and somewhat deep question. To answer it,one needs somewhat more than 800 words,and hence this is the first of two articles on the issue of the fair value of the rupee,today,in August 2013. At least two are needed because the subject is complicated,controversial and confusing. In this first article,I will discuss some important background issues. The next will contain estimates of the fair value of not only the rupee,but also some of the other emerging market currencies in trouble today,for example,the Brazilian real,Turkish lira,South African rand,etc. In order to keep your interest,let me reveal a spoiler — the Indian rupee has overshot significantly and more so than any other comparable currency.

The most significant background issue pertains to the determinants of the value of a currency. And there are several important causal factors. Some of these factors are opaque in principle but not in practice. Take confidence in the government. Regardless of the economic content,if investors believe that the authorities are not confidently in control,they will not buy assets in the country,that is,they will sell the currency. Symmetrically,even if the present situation is bad,investors will buy into the future if they believe delivery is around the corner. Then there is pure politics — the surest way of making investors flee is by sacrificing the country’s potential and agenda by indulging in narrow electoral politics. The problem with these two important determinants is that they are subjective,and not-quantifiable. But that does not mean they are not important.

What are the important quantifiable determinants of what a currency value should be? There are three,though the “experts” generally talk of only two — higher than “normal” inflation and/ or higher than normal current account deficits (CAD). Both are important,and obvious,determinants. When the current account is negative,one is living beyond one’s means — one is borrowing from others,and the ability to pay back these loans is a function of an improving current account. When inflation is “high”,one is losing competitiveness in exports and the exchange rate needs to depreciate to “compensate” for this loss of competitiveness. What is missed by many is the most important third factor — growth acceleration,which makes a currency stronger,and growth deceleration,which makes the currency weaker.

Before I pontificate further,please allow me to introduce myself. In an attempt to answer the joint questions of growth and fair value,I was engaged in research since 2005 on the book Devaluing to Prosperity: Misaligned Currencies and Their Growth Consequences (hereafter DTP). This book was published by the Peterson Institute in the US,and in a highly botched fashion by Oxford University Press in India. What is important to note is not that the book was published,but that it almost did not see the light of day. An important reason for the delay: some controversial findings pertaining to the determinants of fair value of two important currencies — the Chinese yuan and the Japanese yen.

Both China and Japan have current account surpluses,so the knee-jerk conclusion of many was that of course the currencies should strengthen. Yet curiously,the reaction of many “experts”,including the redoubtable IMF,was confusingly mixed. Many of these experts felt that China should not revalue,despite having current account surpluses in the 5 per cent of GDP zone,and sustained economic growth rate of 9 per cent plus for over two decades. And these same experts felt that the yen should keep appreciating because Japan had forever run current account surpluses.

DTP provided a different interpretation and recommendation. The first important conclusion with regard to China was that it had systematically “manipulated” its currency to keep it cheap. Why was this in China’s interest? Because a cheap real currency meant that China could be very competitive in terms of its exports. In more than a manner of speaking,it could steal growth from other emerging markets. But how could it depreciate its own currency? Most interventions in the marketplace,like currently in India,attempt to prevent the currency from depreciating. How do you willingly depreciate the currency? By intervening from strength. If a country wants to prevent its currency from appreciating,it does so by buying dollars,also known as accumulating reserves. This aspect of China’s policy was recognised very early by the US treasury; the last time it branded any country as a currency manipulator was China,and that was almost 20 years ago in 1994.

The second controversial/ objectionable finding in DTP was that the current account was systematically in surplus in Japan,but not because of a cheap currency. Despite averaging a current account surplus to GDP ratio of about 3 per cent since 2000,I argued that the yen was greatly overvalued,and that this overvaluation was hurting their growth,and that a continuous overvaluation of the yen since 1990 of about 30 per cent was a major contributor to Japan’s lost decades.

DTP correctly concluded that the key to Japanese growth would be a significant reduction in its overvaluation. Its 30 per cent plus Abenomics (DTPnomics?) depreciation has removed most of the yen overvaluation. The book also concluded that a key to the reduction in global imbalances would be a significant rise in the value of the yuan. The Chinese currency is about the only currency that has appreciated against the dollar in recent years,and it may have a lot further to go. Part II will offer forecasts on the fair value of currencies. The same method will be used to evaluate fair value as was used to assess the value of the yen and the yuan. Will these forecasts be just as accurate?

The writer is chairman of Oxus Investments,an emerging market advisory firm,and a senior advisor to Blufin,a leading financial information company