GalaTime

There’s no shortage of speculation on the Indian rupee’s future - I too wrote an introductory post on this topic. With the rupee’s recent move from 46 to almost 44 versus the USD, pundits have resumed talk of strong FII/FDI inflows, peaking of the US interest rate cycle, and so on. So what is the INR’s fair value?

There’s several ways of answering this and a commonly-used one is the Real Effective Exchange Rate (REER). Per the United Nations, the REER is defined as “a nominal effective exchange rate index adjusted for relative movements in national price or cost indicators of the home country and selected countries”. [where, the nominal effective exchange rate index represents the ratio of an index of the period average exchange rate of the currency in question to a weighted geometric average of exchange rates for the currencies of selected countries.]

In English, the REER simply takes into account the relative inflation rates between countries. It’s based on the concept of purchasing power parity (PPP); which says that the exchange rates of currencies are determined by their relative purchasing power. The Economist took PPP to the extreme with its Big Mac index - why bother with economics when you can simply compare the price of the Big Mac hamburger sold by MacDonald’s and determine PPP? [And it's beyond me why the magazine doesn't index the INR - maybe because we made McDonald's substitute lamb for beef !!]

So, is REER the answer to valuation about the rupee? Not quite. As the Hindu points out, there’s several holes in the REER approach - the biggest one being its reliance on current account (e.g. trade-related) data instead of capital account (e.g. FII, FDI, interest rate differentials, etc.) data. Another Hindu article talks about how the REER has lost its predictive powers over the last decade.

And then there’s all the talk about the RBI intentionally keeping the rupee weaker to help Indian exporters (specifically vs. China) and IT companies, citing the rapid build-up of foreign reserves (from $1B in 1990 to ~$140B in 2005) as evidence.

My take - watch the INR:USD charts, interest rate trends in the US and India, FII inflows in the stock market and gold prices to get a sense of where the rupee is headed.

This entry was posted on Saturday, January 14th, 2006 at 4:50 pm and is filed under exchange-rates. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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