Currency Valuation- Arithmetic Simplified
How many of us used to notice or talk about rupee levels until 2008 when rupee became a victim of US Sub-prime crisis and depreciated massively from the level of 40 against the US dollar to almost 50 in less than a year. The Indian rupee continues to depreciate against the US dollar and has fallen over 30 percent since 2008 with a couple of spikes in this run-up at times of global distress when India witnessed significant capital outflows. Now when it comes to rupee, every one of us has a level and view to contribute to. But rupee valuation still remains a mystery to masses in financial society.
Simplified currency valuation will help share trader
First, let us look at one very important aspect of currency arithmetic. If asked, how much is rupee depreciation in a period when rupee moved from a level of 40 to 60 against the US dollar, the most obvious answer would be 50 percent. However, the correct answer is 33.3 percent rather than 50 percent as the US dollar is quoted against the rupee not the other way round. So we can say that the US dollar has risen by 50 percent against the rupee but that does not mean that the rupee has depreciated by 50 percent against the US dollar.
To understand this concept better, see it from a foreigner’s perspective having one US dollar at the start of this period which would fetch him 40 rupees. But the same dollar would get him Rs 60 at the end of the period which indicates that the US dollar appreciated by 50 percent against the rupee.
From an Indian perspective, a sum of 120 rupees would have fetched him 3.00 US dollars at the start of this period. But the same sum of rupees will earn only 2.00 US dollars at the end of this period, indicating 33.33 percent depreciation in rupee’s value.
The basic valuation arithmetic for a currency lies in its Purchasing Power Parity (PPP). It states that inflation differential between two countries should drive a currency value. For instance, assuming that inflation in India is 8 percent compared to 2 percent in the US then rupee should depreciate by 6 percent per annum.
Real Effective Exchange Rate and Nominal Effective Exchange Rate
These are broader parameters which indicate the relative value of a country’s currency respect to its online trading partners in the medium to long-run. REER indicates a weighted average value of a country’s currency with respect to other major currencies being traded with after adjusted for inflation. To put it simply, it underscores the export competitiveness of a country in relation to its online trading partners. On the other hand, NEER reflects the unadjusted trade-weighted average of a country’s currency. In case of India, the major online trading partners are euro zone, the US, China, Japan, Hongkong and UK.
Generally, rupee is considered to be overvalued if REER is above the mark of 100 and vice-versa. However, there are extensions to REER which also adjust for growth differentials between two countries in addition to the inflation differential. Hence, a value over 100 may not necessarily be a sign of overvaluation in any currency after adjusting for growth differential. It is seen that a currency tends to revert to its fair value in the long-run after any major deviations from its fair value. Currently, rupee’s REER stands at around 116-117 which suggests a 16-17 percent deviation in rupee value from its fair value. Considering growth differentials between India and its trading partners, rupee does not look beyond 2-3 percent overvalued at this point in time.
Illustration: Rupee REER
Having discussed all the above parameters, another important aspect of currency driver is a country’s central bank monetary policies. A central bank uses its monetary policies to have an optimal and desired level of respective currency liquidity in the system. The US Federal Reserve, for instance, has flooded US dollar liquidity in to the US economy in the aftermath of sub-prime crisis to pump up the US economy. Consequently, the US dollar has remained consistently under pressure until recently when the US Federal Reserve has hinted at tightening dollar liquidity by raising policy rates early next year. In addition, for a country like ours, the central bank keeps a check on excessive currency movements by intervening directly in forex markets from time to time.
Though the underlying parameters like inflation and growth differentials remain significant drivers of a currency in the long-run, a lot many other parameters like capital inflows/outflows, monetary policies, sovereign ratings and central bank intervention have an influence on a currency in the short to medium-term.