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Decimal Digest
07 May 2012

What is the true worth of INR?

In the past six months, on two occasions, INR has depreciated beyond 53.75 against USD; and on both the occasions, RBI had announced significant measures for easing flow of foreign borrowings into India (read: offer higher interest rates to non residents).

This has lead many market participants to believe that RBI is trying to defend 53.75, in spite of repeated assurances by RBI that it does not try to defend any particular level of exchange rates.

If we were to believe that RBI takes 53.75 as defendable true value of its currency, then one can construct an implied table of past true values of INR, based on PPP. One can then compare the implied values with actual market rates, and arrive at extent of historical over- and under- valuation of INR, assuming the current rate being true rate at which external competitiveness of India is balanced.

The chart below has three panels, showing the implied values, actual rates, and inferred over/under valuation.

Chart 1: Analysis of Exchange Rates

Source: Decimal Point Analytics

A quick glance at the right-most panel of the above chart shows that if we assume that the current exchange rate is appropriate, then a decade ago, INR was undervalued by about 40%, and the undervaluation continued till 2007. In fact, a quick analysis of Indian BoP shows that during this period India posted a very modest and rare current account surplus, belying the extent of implied undervaluation.

Also, the same panel implies that INR was correctly priced just before the start of credit crisis in 2007. However, if one reads speeches by (and actions of) senior RBI officials during 2006-7, it becomes clear that, at that time, they were thinking that Rupee was unreasonably strong. This was later confirmed by the steep rise in current account deficit over the next five years for India.

Maybe, it is appropriate to conclude that the current RBI action of trying to prevent further depreciation of Rupee are at odds with both, the historical behavior and the recent severe external imbalances faced by the country.


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