Exactly, headline is derived from economic definition of money,
"money is what money does", which is applicable to Rupee too. As per economic definition, value of
Rupee is determined by its purchasing power parity (PPP) compared to
international standards. But is this definition holds true in this turmoil
markets? I don't think so.
In recent days Rupee depreciation or speed of depreciation has
not only become big issue domestically but also international commentators are
expressing their opinions. There are various research reports available in
markets now on Rupee’s next target. Some brokerage houses are predicting it
will touch 70+ against Dollar and some are telling it will go back to 60/Dollar.
Now everybody is watching whether Rupee will touch 70 before 60 or 60 before
70.
Most of us by now know the macroeconomic issues India is facing
due to which currency is moving in this fashion. But here I am trying figure out
how things change in the micro level or ground level.
Till early May of this year currency wasn’t our big news or
concern, analysts were thinking about macro issues like current account deficit,
fiscal deficit, inflation, RBI’s stance on monetary policy and etc. By this
logic nothing substantial happened on macro front, which wasn’t priced in the
market at that time.
But in May U.S. Federal Reserve chairman Ben Bernanke first time
talked about scaling back the monetary stimulus (Fed is buying $85 billion worth of bonds every month) because of moderate growth in U.S. economy. Immediately
after his statement bond markets reacted very sharply and bond yields
started spiking. At that time U.S. Benchmark 10 year bond yields where trading roughly around
1.6% and Indian benchmark yields where around 8% as shown in the below two
graphs.
Investors were coming to India as there was
arbitrage opportunity or interest rate parity due to yield spread between the
two countries. Even after incurring currency hedging cost of around 6% foreign
investors were making 2% (8% bond yield – 6% currency hedging cost) risk free
return.
But once U.S. bond yield crossed that
crucial 2% level investors thought investing in U.S. bonds is more profitable
than investing in India with less risk. So funds from bond market started
flowing out of India and till now roughly $4 billion went out of India according
to one estimate.
At the same time U.S. stock
markets started regaining their historical highs and were touching new highs
due to which money from equity markets also started changing hands. Because of outward movement of money Dollar demand increased and Rupee started depreciating
as shown in the third graph. But after initial sell-off in the currency market,
sentiments drove the markets with more speed and quantity leading to panicking
situation making policy makers nervous! Policy makers did take some half
hearted measures and did not convince the markets either through their
communication or from their actions leading to rout in the markets!
After this heavy sell-off Finance
Minister and some analysts are saying Rupee is undervalued due to overshooting
of currency markets. One of the popular indexes to measure the valuation of the
currency is Big Mac Index. It gives a rough picture of how a country’s currency
is trading in real exchange terms or purchasing power parity. It compares cost
of Big Mac of McDonalds in U.S. with other countries.
McDonalds’ Big Mac not sold in India since beef is not common; but it is replaced by Maharaja Mac made up of Chicken. As per latest available data cost of
Big Mac in U.S. is $4.56 and Maharaja Mac in India is Rs. 100. So PPP of India is
21.93 (100/4.56). According to Big Mac Index Indian Rupee is undervalued 68% [(21.93
– 67.5)/67.5]. Here I have taken 67.5 as exchange rate of Rupee. Indian
currency is the most undervalued currency as per Big Mac Index.
