Last few days were really busy as I have taken self responsibility of watching each and every match in the IPL - 3. So I am writing after some gap. In this post, let us talk some economics - some currency economics.
This is a great time to observe stock markets and currency markets. As far as Indian stock markets are concerned, they make lot of buzz. But for me, more important markets are currency. Partly because I like them very much and partly because they are really important from macro economy point of view in that they impact real variables like inflation, interest rates and export - import directly. Without getting in to further debate about which market is more important, we move ahead to the actual subject of the post as all agree that both the markets are sufficiently important enough to be studied in depth.
Over the period, I have learned at least 5 different methods of valuing the currency for any country against any other country. Of course, these methods are internally consistent. Using these methods, I was trying to forecast the exchange rate between rupee and American Dollar. The problem is that my forecast is entirely different than that of many analysts and experts. This has not only puzzled me but also motivated me to study the valuations more deeply and I shall do so in coming few weeks. But here I present one or two methods I use to forecast the exchange rate between these two currencies: rupee (Rs) and American Dollar ($).
The first is Interest Rate Parity theory used to predict the exchange rate. It is really simple. Consider 10 year Indian Government Bonds, which are not that risky. These are yielding around 7.80 % annually currently. On the other hand, US Treasury bond (US Govt Bonds) having same maturity of 10 years is yielding 3.60 % annually. So it is clear that (and what follows is based crucially on the assumption that Indian Government is in substantially sound financial situations, that they won't default) an American investor would like to invest money in Indian bonds and earn an extra 4.20 % annually. So what he can do is to take some $ say 100 $, convert them to Rs (at current rate which is 45 Rs per $ roughly) and invest 4500 Rs in government bonds for 10 years. At the end of 10 years he gets lump sum amount of 9535 Rs (this is including interest and note that this is not how bond market works, in the sense that he will actually get his interest on annual or semi annual basis and original face value at the end of 10 years). Now IRP says that the exchange rate must be such that it makes investment in India and US effectively equivalent for any investor. That is investor must earn same return whether he invest in India or USA. In US, this investor would have got 142 $ after 10 years if he would have had invested in US Bonds. So after 10 years 142 $ must be equivalent to 9535 Rs. This means the exchange rate must be 67 Rs per $. So according to this theory, rupee should depreciate against dollar in coming decade. What if this theory does not hold? Then anyone can borrow money at say 4 % (at marginally higher rate as compared to what government borrows money for from the market) and invest in Indian bonds and get something (3.80 % annually) more than what he borrowed, thereby making money out of nothing. Now such free opportunities are not tenable, because everyone will try to do it, thereby pushing up the interest rates in the USA substantially higher eroding such profitable opportunities.
Now analysts say, that Indian growth story implies that foreign investors will invest money in Indian economy and that means higher demand for rupee and appreciation against dollar. The logic is if this is the case, then anyone can exploit the kind of arbitrage opportunity presented above and make infinite amount of money. So either analysts are wrong or someone can make free money. If this is so, analysts can make free money too and the fact that they are not making money but projecting appreciation of rupee implies that they must be wrong. So their actions reveal something different than what their reports do. Is it really the case? This is puzzle number 1 in front of me.
Historically, IRP has been able to give more or less correct results at least over a longer period of time. I mean currency of country having substantially higher interest rates have generally depreciated against currency of the country having lower interest rates. In fact Rupee has depreciated against Dollar over last 10 years from 25 - 30 Rs Per $ to 45 Rs per $ (touching high of 52 Rs per $ in the interim). So, theory seems to work in spite of many unfulfilled (implicit) assumptions in the theory.
Given this dilemma, I am all set to take this study further and come up with some credible valuation of Rupee against Dollar. Till then Goodbye
