In his speech on India: Economic & Political Outlook at IMC Mumbai 16 June 2016, Subramanian Swamy remarked that the exchange rate of the Rupee vis-a-vis the Dollar should be closer to ₹30 (today it is ₹67). How did Dr. Swamy arrive at the number of 30? There are several ways to determine this and the first one we will look at is the Big Mac Index.
Every year, around January, the Economist publishes a Big Mac Index as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in January 2016 was $4.93; in China it was only $2.68 at market exchange rates. So the “raw” Big Mac index says that the yuan was undervalued by 46% at that time.
Similarly, in India, a Big Mac costs $1.90, which implies that the Rupee is undervalued by 61.4%, thereby indicating that if PPP were the only criterion to determine exchange rates, the Rupee would have an exchange rate of ₹25.76.
The relative version of PPP is calculated as:
“S” represents exchange rate of currency 1 to currency 2
“P1” represents the cost of good “x” in currency 1
“P2” represents the cost of good “x” in currency 2
What are the factors that are preventing the exchange rate from reaching this level (or something close to it, say ₹30)? First let us look at the pros and cons of an appreciating Rupee:
A rising tide lifts all boats. As the Rupee starts appreciating, the net worth of every citizen will go up.
It would cost less to purchase essential commodities and the artificial hoarding effected by some elements will disappear quickly as they will realize that their goods will be worth less with every passing day. Consumer Price Index would get very close to the Wholesale Price Index. To measure purchasing power, you would compare against a price index such as the Consumer Price Index (CPI). A simple way to think about purchasing power is to imagine if you made the same salary as your grandfather. Clearly you could survive on much less a few generations ago, however, because of inflation, you would need a greater salary just to maintain the same quality of living.
An appreciating rupee will throw the inflation based (assumed) economic models off their axis as an appreciating rupee would keep prices steady or drift lower, giving the appearance of deflation. By being up-front with the messaging, the Government can handle this phenomenon.
Exports will cost more since the same amount of rupees will get fewer units of foreign currency. Exporters will need to get more efficient to adjust to this new reality.
So how does one bring down the Rupee vs Dollar exchange rate? In the same speech Dr. Swamy mentioned that the exchange rate is affected due to Foreign currency speculation, Black Money and Participatory Notes. Assuming that these are the prime causes, the sequence should be as follows (in my opinion):
Ban Participatory Notes: Also referred to as P-Notes, they have been causing a fair amount of volatility in the Stock Market. Banning them may cause a Stock Market correction but the true value of the stocks will be revealed, allowing for accurate Price Discovery.
Temporarily halt Foreign Currency Speculation: This is a must to get a grip on the Foreign Reserves. To ensure a smooth ramp up of exchange rate, any disturbing factor should be kept on hold.
Additionally, India needs to ink Energy deals (Crude Oil especially) with suppliers in non-dollar terms. This too will add stability to the exchange rate.
Lastly, pass a bill to Nationalize all assets of Indian citizens in Tax havens. This may lead to an exodus from the country of the wealthy but the law should have teeth to go after their assets even if they have transplanted themselves abroad. What about the Black Money inside India? This is mostly in the form of real estate, be it buildings or land. The stoppage of P-Notes will curb the generation of Black Money inside India (along with PAN card / Aadhar’s usage for more high value transactions). The owners of unsold housing may sit on it and try and ride it out but recently Vancouver Canada has proposed to tax the owners of unoccupied housing too. A similar law passed in India will bring down the prices fairly quickly.
All this requires political will and the ability to ride out storms. Will this happen? Only time will tell.
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