The Indian rupee, like other emerging market currencies, experienced sudden and significant depreciation on fears of the US Fed "tapering" in mid-2013. From an average of 55 INR/USD in May 2013, the INR depreciated by 15% over just 3 months, to 63.2 INR/USD in August 2013 (it touched an intra-day record low of 68.8 INR/USD in August 2013). The currency settled at 61-63 INR/USD range in recent times due to significant efforts from the Indian central bank (RBI), which prevented further depreciation. But despite the significant depreciation, has INR depreciated enough, considering the fact that the Indian economy has been experiencing significantly higher inflation compared to the rest of the world? We will examine it here.
Price levels and exchange rates: A perspective from Relative Purchasing Power Parity theory
One of the major theories for determining the expected movement in exchange rate between two currencies is the Relative Purchasing Power Parity (RPPP) theory. This theory says that the currency of the country with higher inflation rates will depreciate compared to the country with lower inflation rates.
Inflation reduces purchasing power. So, the country with higher inflation experiences higher erosion in purchasing power. Thus relatively speaking, the purchasing power of the country with higher inflation, decreases when expressed in terms of the currency of the country having lower inflation. As per RPPP theory, this relative erosion in purchasing power will be compensated by changes in nominal exchange rates, so as to bring the purchasing power of both the countries to same levels.
Let us examine the movement in exchange rate between USD and Indian Rupee (NYSEARCA:INR) vis-à-vis the inflation differential between the US and India. This analysis is done for the period from April 2004 to October 2014. In April 2004, the exchange rate was 43.9 INR/USD, and in October 2014, it was 61.3 INR/USD.
Let us first examine the inflation differentials between the US and India. Consumer-level inflation indices have been used for this analysis. The below graph depicts the consumer-level price indices in both the countries (rebased to 100 in April 2004):
It is obvious from the above chart that inflation has been very high in India compared to the US. If price of a commodity (in general) in April 2004 was 100 in both the US and India, the price of the same commodity in October 2014 will be 227 in India, while in the US it will be 126. Hence the prices in India are about 1.79 times the price in the US. Hence the exchange rate in October 2014, as per the RPPP theory should have been 78.8 INR/USD (43.93 INR/USD x 1.79). But, the exchange rate in October 2014 was 61.3 INR/USD. That means, INR is 28% over-valued against the USD, than what it should have been as per RPPP.
Despite this anomaly, the below graph depicts that the INR/USD rate movement has been mostly in line with the differing levels of inflation:
Source : India CSO, RBI, US BLS
On the left Y-axis, the green line represents the exchange rate that should have prevailed, based on the inflation differentials; while the light blue line represents the actual nominal exchange rates. On the right Y-axis, the dark blue line represents the price level differences between India and the US (Price in India ÷ Price in the US), i.e., it means that Indian prices are 1.79 times the prices that exist in the US.
The correlation between exchange rate (light blue line) and price level differential (dark blue line) has been 0.87 over the past 10 years. That means, the exchange rates have moved in the same direction with the price differential between the two economies.
Real Effective Exchange Rate or REER: How INR is valued against 36 major trading partners' currencies
The Reserve Bank of India (Indian central bank) publishes, on a monthly basis, a Real Effective Exchange Rate for INR. This foreign trade weighted index compares the Indian rupee against India's 36 major trading partners, taking into consideration the inflation differentials at consumer level. A reading above 100 means that INR is overvalued, while below 100 means that it is undervalued. A reading of 100 points to a fairly valued INR.
The latest REER reading (October 2014) is 109, which points to an over-valuation of 9% against a basket of 36 currencies.
Source : RBI
Despite a significant depreciation of 36% over the past 1-4 years, the Indian rupee still remains an overvalued currency, due to significantly higher inflation levels when compared to the rest of the world.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.