BOMBAY, 10 October 2005 — A proposed revamp of the trade-weighted index India uses to manage the rupee will reflect burgeoning trade with China but will not herald any central bank readiness to loosen its hold on the currency, analysts say.
The Reserve Bank of India (RBI) said last month it would add the Chinese yuan to its real effective exchange rate (REER) index, which it uses as a benchmark for monitoring rupee over- or under-valuation and as one signal for when it should intervene.
Analysts say the revamp is long overdue and will capture India’s contemporary trade flows better.
China has replaced the United States as the biggest source of imports for Asia’s third-largest economy and bilateral trade with China reached $13.6 billion in 2004.
The RBI used to allow the rupee to float in a 3-5 percent band as measured by the index, but this year it has let the currency appreciate by more than 10 percent against that gauge, leaving traders guessing as to what reading might trigger action.
The central bank publishes its REER on a monthly basis but J.P. Morgan has a similar index available daily, which shows the rupee is presently 9.5 percent overvalued at 109.50.
“The new index will reaffirm the relevance of the REER as an important valuation metric,” said Rajeev Malik, J. P. Morgan’s regional economist in Singapore.
Analysts say that, in the near term, simply bringing in the yuan is unlikely to reduce the rupee’s overvaluation, as measured on the existing REER, because the yuan is still largely linked to the US dollar, which is recovering from a three-year decline.
The current REER dates back to 1998 and is a five-currency index — the French and German monies subsequently gave way to the euro — with the following weightings:
• US dollar 38.71 percent
• British pound 16.56 percent
• Japanese yen 18.72 percent
• French franc 6.32 percent
• German mark 19.69 percent
The new one will add the Hong Kong dollar and the yuan and replace the franc and mark with the euro, but the central bank has not given details of their weightings or when the new index will be introduced.
The spot rupee hit a six-year high after China revalued the yuan in July and dropped its effective dollar peg in favor of a currency basket. In reality, however, the yuan has not strayed far from its post-revaluation rate against the dollar. Irene Cheung, an ABN Amro currency strategist in Singapore, said that, as a result, its inclusion in the index would mean that the dollar’s weighting would rise, indirectly.
There is no real market consensus on the likely yuan weight.
Bank of America expects it to be 7.3 percent, J. P. Morgan says 9.9 percent and Deutsche Bank suggests 15 percent.
J. P. Morgan and Bank of America both expect Asia’s total weight, including Hong Kong and Japan, to rise nearly 8 percentage points to 26 percent. Deutsche says Asia’s total weighting could rise to 35 percent. Economists at all three banks say the US dollar’s proportion in the new index will fall to about 30 percent.
“The dollar will still be the largest weight, though its share would drop,” said Rajiv Kumar, chief economist at the Confederation of Indian Industry.
“The RBI would take the chance to get the euro its proper weight and the yuan, I suppose, will also come out of the dollar. With India’s trade still by and large dollar-denominated, the dollar would and should continue to have a larger weight.”
India’s plan to include the yuan gave the rupee a brief lift last month, though growing worries about a record trade deficit and the currency’s dependence on volatile foreign capital inflows to offset that gap have dragged it down since then.