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Why rupee-dollar levels do not depict the true value of India's currency

Why rupee-dollar levels do not depict the true value of India's currency

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Headlines such as "The rupee has appreciated or depreciated 30 paise against the dollar..." appear on a daily basis. Such reports on currency invariably attribute the reasons for currency movement to a government decision, uncertainty in markets, or perhaps even a controversy.

This piece is about knowing the actual value of the rupee.

In India, the de facto way to measure the rupee's value is to compare it to the US dollar. When was the last time you heard of the rupee being valued against the Japanese Yen, despite the fact that Japan has the 3rd largest economy in the world? It is first important to remember that there are two sides to an exchange rate: when the rupee is trading at 62 against the US dollar, it can appreciate to 61 against the dollar due to dollar weakness or rupee strengthening (or both).

In effect, it is possible for both currencies to depreciate and for the rupee to appreciate against the dollar. If the dollar depreciates more than the rupee, then the exchange rate can go from 62 to 61!

And so it becomes fundamentally clear that in order to truly understand the value of the rupee , it should not be valued against only one currency (the US dollar); instead, it should be valued against a basket of currencies to get a better understanding of its true, intrinsic value.

Here is a graph of rupee to dollar (instead of dollar to rupee) which shows the exchange rate for the number of rupees per US dollar, this shows the number of US dollars per rupee). As you can see, the rupee has depreciated 11.93 per cent against the US dollar this year (January 1st - September 26th).

As you might know, India is one of the BRIC countries (others being Brazil, Russia and China) which is at a similar stage of economic development. China's currency (the yuan) is essentially "pegged" to the US dollar, so its exchange rate against the US dollar fluctuates very little because the Chinese government controls and fixes the exchange rate; therefore, we can keep the yuan out of the picture. If we see how the rupee fared against Brazilian real, Russian ruble, and the Japanese yen (to re-iterate, Japan is the 3rd largest economy in the world behind the USA and China) in 2013, we get a very different picture.

As you can see, the rupee has depreciated 4.26 per cent against the Brazilian real, 7.5 per cent against the Russian ruble, and actually appreciated 0.1 per cent against the Japanese yen! What a world of a difference it makes when you simply change the currency you are valuing the rupee against.

So once again, we go back to our original question: what is the value of the rupee? If the rupee's "value" is dependent on which currency it is being compared to, then how do we know if its intrinsic value has increased or decreased?

Unfortunately, there is no clear cut answer for this, but based on the fact that the rupee has depreciated against the majority of currencies, it is safe to say that the intrinsic value of the rupee has declined in 2013. A better approach would be to delve a little deeper into what causes exchange rate fluctuations, and in India's case, what determines the rupee's intrinsic value.

Money supply

Similar to how a local fruit-wala decides on the price at which to sell his fruits to his customers based on the supply and demand of fruits, the rupee's intrinsic value is largely a function of how many rupees there are in circulation. In layman's terms, the less rupees there are in circulation, the higher the value of the rupee.

The money supply of rupees can change due to the trade balance, which is nothing more than how much a country imports versus exports. When a country sells more goods and services to overseas markets than it buys from them, then it has a trade surplus. A trade surplus increases the value of the rupee because it brings in more foreign currency into India than the amount of rupees that are paid for imports.

Interest rates

Last week, the RBI increased the repo rate (the repurchase rate), which is the rate at which banks must borrow from the RBI to meet their short-term requirements. Raising the repo rate has a direct impact on the value of the rupee because it essentially increases the cost of borrowing for the common man and corporations to borrow rupees from any bank; hence, it reduces the money supply of rupees in the market, thus raising the intrinsic value of the rupee.

In many countries around the world, the "carry trade" strategy is commonly used to take advantage of currencies offering higher interest rates than others. A carry trade is essentially the act of selling a certain currency with a low interest rate and using the funds to purchase another currency with a higher yielding interest rate. Thus, a country with a high interest rate generates a lot of foreign investments. However, in India the "carry trade" strategy is not viable since the rupee is not a freely convertible currency. The RBI has strict rules on how many rupees can be converted to another currency. Therefore, the "carry trade" does not have a large impact on the value of the rupee.

Inflation

Last week, I pointed out 5 reasons why RBI's rate hike is good for India, the RBI has made it perfectly clear that its top most priority is to bring down India's high inflation level. Inflation can be deadly when it comes to its impact on a currency. Inflation, of course, is nothing more than the general increase in prices of goods, which leads to a fall in the purchasing power of a currency. The higher the inflation, the higher the pressure on the government to restrict the money supply. That is precisely why the repo rate was hiked last week.

Therefore, when a high inflation number is reported by the government, the rupee usually strengthens because the markets understand that monetary tightening (the act of raising interest rates) is expected to follow.

In conclusion, an exchange rate does not give you a clear picture of a currency's value. The next time you see the rupee appreciating or depreciating against the US dollar, do not automatically assume that the rupee's actual value has depreciated/appreciated. There are many factors at play, and it is this careful balancing act of keeping all these factors in check that gives the RBI a full deck of challenges on a daily basis.

Raghu Kumar is the co-founder of RKSV, a broking company. The opinions expressed here are the personal opinions of the author. NDTV is not responsible for the accuracy, completeness, suitability or validity of any information given here. All information is provided on an as-is basis. The information, facts or opinions appearing on the blog do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.

Story first published on: September 28, 2013 13:53 (IST)

Tags: Rupee, Inflation, Exchange rate, Forex, Interest rates, RBI, Repo rate, Indian rupee, Dollar to rupee, Money supply, Raghu Kumar, RKSV


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