The principal insight of this article is that convergence of per capita incomes between open market economies necessarily and sufficiently implies exchange rate parity and that, as a corollary of this proposition, exchange rates must be directly proportionately related, or are always positively correlated, to per capita incomes.
This article contends that the Indian rupee is grossly undervalued. Indian growth because of US and EU outsourcing and Indian domestic initiatives would have continued since 1989 even if INR was stronger.
At the current Indian per capita annual income of $4000, the rupee should appreciate to INR 13 per USD 1, assuming exchange rate parity or INR 1 = USD 1 at equal per capita incomes. China, despite its political structure, maintains a more equitable exchange rate with the G7 countries.
A key point to note, whether economic policy, as a normative objective, targets gross domestic product (GDP) or not, money supply growth rate is always directly proportional to GDP and is always positively correlated to GDP in the Solovian very long run in accordance with Hume’s Quantity Theory of Money (QTM), implying that the gross national and domestic products (GNP and GDP) of the United States, given the G7 monetary easing, will recover to full employment of about 4% by 2017, 10 years after the 2007 downturn, around the period when all open market economies experienced loss of per capita income. India, once again in its history after 1977, has been more open since 1989 to foreign investment.
The managed exchange rate of the Indian rupee relative to the US dollar was stronger than necessary in 1989 (it should have been INR 27 to USD 1). It is far weaker than necessary now (it is INR 52 to USD 1 instead of INR 13 to USD 1):
- Between 1989 – at the end of the Cold War, when INR was 13 to USD 1 – and now, Indian economy has grown stronger to join top 5 global economies.
- Economic fundamentals, in terms of income disparity, have equally worsened in both USA and India.
- US-India population growth rate, per capita depreciation of capital stock, and diffusion of technical change are also similar.
- If relative US-India per capita incomes are considered between 1989 and now, US per capita income being 13 times India’s per capita income, approximately INR 13 should equal USD 1 in 2012, about the same as in 1989.
On balance, we conclude that the Indian Rupee must appreciate by about 4.33 times to achieve coherence between market exchange rate and official exchange rate and that this is feasible only if the Indian rupee is freely floating in an environment of high domestic investment toward structural reform.
(Fully copyrighed to Transformations, LLC, 2012; Per Capita GDP data from http://www.indexmundi.com/factbook/countries)