What will be the stable value of the Rupee in the foreign exchange market?

Several persons in the trade have asked me where I think the Rupee exchange rate will settle at. Some thought it would go to Rs. 140 while some even thought it would go to Rs. 150.

What ideas do economics have to offer? Firstly it must be stated that any overvaluation of any currency will eventually be corrected either through a massive devaluation or exchange rate collapse.

We are seeing the first.

As there was an unsustainable pressure on the Rupee caused by the increase in import expenditure the Government in the Budget Speech devalued the Rupee by 3%. So by end 2011 the Rupee had depreciated by 2.59% to Rs 113.90, owing to cross-currency movements the Rupee appreciated by 15.01% against the Indian Rupee.

Since the policy of pegged Rupee was causing an erosion of the official foreign exchange reserve the Central Bank decided to float the Rupee in February 2012 and limit its intervention in the foreign exchange market.

Hence it will supply foreign exchange from its reserve only to pay the petroleum bills and to absorb the supply of surplus foreign exchange liquidity that would flow into the market from various sources including the receipts of Tier-2 capital for commercial banks, inflows to equity and bond markets etc., that may otherwise lead to an undue appreciation of the rupee. The latter circumstances have not arisen. Instead the Central Bank seems to be buying the normal supply of dollars coming into the market which naturally increase the depreciation of the Rupee.

Economists look to the Real Exchange Rate to determine the extent of overvaluation of the nominal exchange rate. The

Real Effective Exchange Rate according to the Central Bank Annual Report was 80.92 in 2007 (2010 = 100) and is 102.07 in end 2011. This means that there has been a real exchange rate appreciation of 21.15% between 2007 and 2011. The nominal exchange rate has appreciated by 0.87% between 2007 and 2011. The Rupee has so far depreciated by 16.8% from the Rs 113 to the dollar since 21% depreciation is needed to remove the over-valuation a further 4% depreciation is likely.  Any over-valuation of the Exchange rate is sooner or later corrected and we should therefore see some stability soon in the Rupee with a possible 4% depreciation at the most. But markets tend to overshoot and under-shoot and the Central Bank has to be vigilant to intervene if necessary.