Recent fall in Rupee Vs Dollar exchange rate is quite problematic for India Rupee and Imyself found it very disturbing for indian Economy. The first image shows the recent Rupee Vs Dollar Exchange rate and one can easily see that Rupee has depreciated a lot. Surprised by the above finding I tried to dig it further.
I took US and Indian CPI monthly data and tried to get some insight regarding this depreciation of Rupee. The idea i am using is famous purchasing power parity. In simple sense what it says is as follows: Suppose one product is selling at 40 Rupee per unit when exchange rate is 40 Rupee per dollar and because of inflation if the price of product become 60 Rupee and price in dollar remains constant, then Rupee must depreciate and new exchange rate must be 60 Rupee per dollar according to purchasing power parity ( real exchange rate remains constant one dollar for one product before and one dollar for one product now as well). The same argument can be extended in relative terms like this. The inflation in india was 50% [(60-40)/40]*100 and zero in US, so relative inflation in India was 50% and so Rupee must depreciate by 50%. If Rupee depreciates less than what is given by Purchasing power parity it means that Rupee is being overvalued and exporters loosing competitiveness. If it depreciates more than that, it means Rupee is being undervalued and our exports are being more competitive. Thus what relative purchasing power parity says that relative price change must leads to change in exchange rate. Relative price rise leads to equal depreciation and price decrease to equal appreciation to maintain purchasing power parity.
And that is the idea of second Figure. Where i have plotted monthly US and Indian CPI and monthly Rupee Vs US dollar exchange rate , all indexed to january 2000 as 100.
and what this says that between january 2000 to april 2012, Indian Rupee has depreciated only 18.6% in dollar terms whereas between January 2000 to february 2012 the relative price rise in India in comparison to US has been 78.1% and in the same duration Ruppe has depreciated by 12.8% only. March and April data of CPI not in Fred data base so could not be Used.( Accumulated price rise in US during the period being 35.9% and in India 113%). So according to purchasing power parity Rupee has not fallen a lot and still need to depreciate according to relative purchasing power parity. The same is shown here in figure 3. The relative price increase in India and depreciation of Rupee.
The above figure shows that rupee needs to depreciate further to maintain purchasing power parity. As according to relative purchasing power parity the red and blue line must be moving together and since a lot of gap has arisen one can easily infer that Rupee in a sense is overvalued today and could be one reason of our lagging export growth.
So what seems to be volatility and sentiment in foreign exchange market is basically driven by Economic Fundamentals. It also shows the complete failure of the RBI and the government in managing inflation. It will be quite awful to blame investors for recent fall in Rupee. It would be better to curb inflation by both demand and supply side measures rather than supporting fall of Rupee by other means which is purely Driven by Fundamentals. And at last although purchasing power parity has its own caveat but here it gives indication that recent fall in Rupee is driven by Fundamentals and must not be Surprizing to all who understand little bit of Economics.