The Nominal Effective Exchange Rate (NEER)
has appreciated by 4.4 % between 2006 and 2014 and has depreciated slightly in
2015. Can we thus claim that this suggests an expansionary monetary policy.
No, the claim is not automatic. For instance, the depreciation may be
offset by an increase in domestic prices relative to foreign prices or it may
reflect a deterioration in the terms of trade ( i.e not in response to monetary
policy decision, but due to some change in world conditions).
One needs therefore to focus on the behavior of the
real exchange rate relative to its neutral or equilibrium level. A depreciation
in the real exchange rate signifies a drop in the relative prices of domestic
to foreign goods. But even such a depreciation would not necessarily result in
an increase in demand if the equilibrium level of exchange rate fell as well.
Over the last decade, the real effective exchange rate(REER) has been
experiencing an appreciating trend and since 2015 it has been
depreciating slightly.
Evaluation of a depreciation : The
impact of a change of the exchange rate (real and nominal ) on the current
account is not certain; it depends on many factors which include the price
elasticity of demand for exports and imports, the competitiveness of other
textile producers for e.g, the situation of the economy or the output gap,
economic growth in other countries, the pass-through effect, among others.
In the case of the latter,
an IMF study (2010) titled “Monetary Policy Transmission in Mauritius Using a
VAR Analysis “ by Charalambos Tsangarides found that a change in the nominal
effective exchange rate has no statistically significant effect on output
in the short run. The reasons given at that time for the apparent lack of a
transmission to the real sector of the economy were the structural rigidities in
the financial system and the regulatory framework.
Among the other factors we
can also consider the existence of the import content of exports, as well
as the dynamic effects of productivity improvements. In the presence
of high import content, exports are not adversely affected by
currency appreciation because the lower import prices due to appreciation
reduce the cost of export production. Moreover, productivity
gains can counter the negative effects of currency appreciation.
The dynamics of
the real effective exchange rate (REER) and its impact on the country’s current
account are rendered more difficult by the continued large inflows from the
global business corporate (GBC) sector which contributed some 7.4 % of GDP to
the current account and 23% of GDP to the overall balance of payments in 2014.
Thus the impact of the appreciation of the rupee on the current account could
have been mitigated by the huge investment income inflows from GBC investments
in the rest of the world.
Indeed, real exchange rates
and current account balance do exhibit seemingly inexplicable behavior. for
e.g. the appreciation in the real exchange rate can lead to an improvement in
the current account deficit. This may be explained in terms of the
‘home-good preference’ that refers to the simultaneous rise in demand and
supply following an improvement in productivity and declining exchange rate
pass-through. (Blanchard et al.2005-The
US Current Account and the Dollar) In our case despite a generally
deteriorating terms of trade and the ups and downs in the current account
balance, the real exchange rate has continued to appreciate. One of the
factors that could explain this appreciation of the rupee is the
surge in capital inflows since 2006 that
more than compensated the current account deficit. The small depreciation in 2015 over the previous year could be because of relatively lower BoP surplus in this year.
The next question is whether the real exchange rate is overvalued or undervalued ?
According to the IMF the real effective exchange rate is broadly in line with fundamentals. Its results show that the deviation of the REER from its equilibrium is less than 5%. But this is based on the assumption of continued large inflows from the offshore sector. IMF also noted that excluding these inflows from the current account would imply an over-valuation of the REER by more than 25%.
Thus
without a proper investigation of all the mix of factors that are affecting the Current Account Balance and the REER, it will be erroneous to
conclude too rapidly about the direction of monetary policy and on the effectiveness or ineffectiveness of a restrictive
(strong rupee) or expansionary (weak rupee) monetary policy.
