Why using CPI for REER calculation has been self-destructive for India

From production to consumption, there are three major economic decision-making links – consumers, wholesalers/traders and producers. 

Of these, the consumers are driven by satisfaction and operate with a large price band. If he likes a brand, he might pay 20-30% more even when he knows that the products are functionally the same. For most products, superior alternatives are available through imports which might come within his price band. 

The wholesalers are profit driven. They would always try and push products which give them maximum margins – sure, consumer satisfaction counts but will become incidental beyond a point. The manufacturers similarly are cost conscious. They would compare the costs item by item and, even for minor differences, switch from expensive to less costly substitutes and sources.

Ideally, currencies should be so valued that they have a neutral impact on trade which should be based purely upon inherent comparative cost and efficiencies. For this to happen, the Real Effective Exchange Rates (REER) should be at parity (=100). This means that the traded value of currencies continually adjusts to the differences in inflation between the trading partners. If not, the products from countries with higher inflation (and hence prices) will lose their existing advantage to the lower inflating country.

WPI or CPI depends on who decides to import

Which prices should we be using for measuring inflation? Theoretically, it can be the CPI at the consumer level, WPI at the wholesale level or factor cost levels, which are rarely used. Most countries use the prices at the consumer level (CPI) recommended by the IMF's model for calculations. India used WPI up to early 2014 and switched to CPI when more reliable estimates began being constructed as CPI inflation in India.

Exchange rates come into play for comparing prices between imports and domestic supplies. The prices we use should then ideally depend upon who makes the decision and how he does it.  

In consumer products, the ultimate consumer is not the one importing except perhaps when he goes abroad. The trader importer places the orders for import even if influenced by end consumer preferences. If the margins on imported products are not commensurate, he will try and push more domestic brands. They exhibit neither patriotism for domestic sourcing nor brand loyalty for imports beyond a point. Again, if he decides to import, he does not visit the retail markets abroad to source his material; he would mostly be sourcing from wholesalers or wholesale markets.

In the case of raw materials and intermediate goods for industrial use, wholesale prices count. No large manufacturers or traders operate through retail markets in India or abroad to source inputs.

Large industries like Japanese manufacturers sometimes negotiate prices based on input costs and factor costs. But such sourcing is more confined to their ancillary units.

Thus, in not many cases, the CPI prices and factor costs come into play as domestically as Wholesale prices. Any large differences in WPI will affect trade competitiveness not entirely accounted for by CPI inflation movements which guide REER calculations and forex management by RBI.

So even if RBI gave up the WPI base in 2014, it should have continued calculating and disseminating REERs based on the WPI of trading partners and, where possible, factor cost movements. It would have signalled developments in loss of competitiveness more quickly than if CPI indices were used, which has a lot of slack from consumer's price bands and wholesale margins.

Dangers of chain indices

The problem is compounded when we move into chain-based indices rather than indices based on a fixed base year, which is reset once every 5-10 years. All the adverse trade un-competitiveness till the beginning of every year is blissfully forgotten in calculations, although businesses continue to suffer from the underlying cost, technical and efficiency handicaps. Over an extended period, they accumulate to a sizable percentage. This is even more detrimental to our interests than switching WPI to CPI.

Should it matter?

It should not usually matter which prices are used in REER calculations if CPI, WPI and wholesale trading margins move in tandem in both markets – in India and overseas. This is essential. It is not always the case as is being witnessed now. India's WPI indices are hovering persistently in double digits, 12-15%, whereas CPI has been hovering around 5-7% for the past several months. This will seriously dent manufacturing margins for exporters and trading margins for wholesalers from domestic sourcing. And India might lose the momentum seen last year in its exports very quickly.

Calculating coordinated and synchronised reporting to WB or the government is one thing, but facilitating trade, economy, and employment is another. Indices don't create employment; competitiveness does. It seems more prudent to use fixed base year WPI-based REER, even if informally, to guide policies and promote better-informed debate.  

Most East Asian Miracle economies have undervalued their currencies during their growth phase to compensate for additional costs imposed by their poor infrastructure. Indonesia and Malaysia continue to play it now. Philippines' central bank publishes on its website three separate indices, i.e., vis-à-vis Advanced countries, developing countries and overall. Although not stated explicitly, it uses the last index, which is more conducive to tilting trade in its favour. Given its stage and uncompetitive infrastructure, India's approach has been largely naïve or self-destructive.

The writer is the author of Making Growth Happen in India (Sage)