Is the Rupee Overvalued? Not Everyone Thinks So

Is the rupee really overvalued, as many believe? And is the RBI intervening less to allowing it to strengthen?

4 min read
A run of strength in the rupee, which started earlier this year, has persisted. (Photo: iStock)

A run of strength in the rupee, which started earlier this year, has persisted. The Indian currency remains one of the three best performing units in the Asian region, having gained more than six percent since the start of the year. On Wednesday, the rupee strengthened to levels above 64 against the US dollar in intraday trade for the first time in 20 months.

The common refrain in response to this surprising upturn, is that the rupee is now overvalued. An almost equally common belief is that the Reserve Bank of India (RBI) is intervening less, which is allowing the currency to run-up.

Not everyone agrees. Pradeep Khanna, head of trading at HSBC India, for one, disagrees with both those narratives.


“I am not sure the authorities look at it like that. The government doesn’t seem to be too concerned, the RBI seems to be far more tolerant,” Khanna told BloombergQuint in a phone interview.

If I look at the REER data, I don’t get the sense the rupee is overvalued.

The REER or real effective exchange rate is measured through indices that the RBI compiles. One, the more commonly used, measures the strength of the currency vis-a-vis a basket of currencies of 36 trading partners. The latest reading on that index pegs it at 117. The second index measures the REER against a basket of six major trading currencies, and that index is currently at 130.

In explaining the level of that index, Khanna borrows from former RBI governor Raghuram Rajan, who had pointed out that given the productivity growth differential between a developing country like India and developed nations, some appreciation in the currency can be justified.

If you look at it and say that there is a 20-25 percent overvaluation over a base year of 2004-05, and if you say that 2 percent per annum compounded is something we can handle, then we are not overvalued. If you look at 2014-15 as a base year, then it looks like we are 6-7 percent overvalued and the same calculation holds.
Pradeep Khanna, Head Of Trading, HSBC India
(Photo Courtesy: BloombergQuint)
(Photo Courtesy: BloombergQuint)

Changing Patterns of Intervention

Khanna also disputes the premise that the RBI is intervening less. They are intervening differently, he said.

In the past two years, one of the clear objectives of the RBI was to build forex reserves to provide a buffer to the currency. The central bank also wanted to ensure that foreign currency non-resident (FCNR) deposits, raised in 2013 to protect a falling rupee, can be repaid without any pain when they come due in 2016.

In keeping with this objective, the RBI mopped up dollar flows from the market aggressively in 2014 and 2015. As a result, reserves have risen to about $370 billion now from under $300 billion in September 2013.


Now that reserves are seen as adequate and the repayment of FCNR deposits is complete, the RBI’s objective behind invention appears to have shifted towards largely managing volatility, Khanna added.

A prime objective of intervention at that time appeared to be reserve replenishment. In today’s scenario, that doesn’t appear to be the primary objective. It really does seem like they are just smoothing the volatility beyond a point. So the pattern is a bit different but quantum does not appear to be lower.

(Photo Courtesy: BloombergQuint)
(Photo Courtesy: BloombergQuint)

Headroom For Debt Flows

Khanna, like most others, has been surprised at the strength of the rupee. HSBC had a target of 69 for the rupee against the US dollar by end of 2017. This was revised earlier this year to 67.50. Part of this revision in target was due to a change in the view on the US dollar itself, where anticipated strength in the currency following Donald Trump’s victory had already been factored into the market.

Apart from a change in the global currency outlook, strong inflows into the debt and equity markets have unpinned gains in the Indian currency.

More than Rs 90,762 crore in foreign inflows have come into the markets since the start of this year shows data from the National Securities Depository Ltd. Of this, Rs 48,650 crore have flown into Indian debt. This could continue, given that just over 70 percent of the foreign investment limit in the government securities market has been utilised.

Foreign investors see enough reason to invest in Indian debt, particularly in shorter-term securities, said Khanna. A return of funds that exited in the latter half of 2016 and a churning of portfolios within emerging markets are factors driving money into India.

There is clearly headroom for flows coming into the debt market. Partly the money that we have seen coming in is money that went out last year so we haven’t lost the headroom. Also I think there is a fair amount of appetite to buy on the short end of the curve. The regulatory minimum tenor of 3 years applies but I think in the 3-5 year bucket, there is a fair amount of interest to buy.

(This article was first published on BloombergQuint.)

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