The Exchange Rate connundrum

Over the last one month the fall in the rupee value vis-a-vis the dollar has led to a lot of discussions and debates on the reason for the same. Most of them have been on the FII outflows from the Indian bond market or increasing CAD. But is that the only reason? When two items are valued relative to each other, the fall in their value in relation to a constant has to be considered as this determines the relative movement vis-a-vis each other. Similarly while considering the fall in value of a currency relative to other currency the fall/rise in value of the currency with respect to a constant has to be considered.  The constant factor for currencies is the relative inflation rates in each of the countries. Hence the formula, Exchange rate (year 1) = Exchange rate (year 2) X (1+Inflation in country 1)/(1+ Inflation in country 2)

The above formula is a long term equilibrium, there will be short term variations due to demand supply restrictions. However the inflation rates in each of the countries will determine the relative values in long term. Let us have a look at the actual exchange rate (US$/INR) versus the formula derived value (US$/INR),

The above graph shows two distinct periods, period 1 (1995 to 2006) and period 2 (2009 to 2013). Period 1 has been a period where the formula and the actual rates were very close to each other. In the second period, the relation has been unraveled, the gap between actual and formula based rates shows a very large difference. It is fault line which has been created due to the money movements arising due to continued easy money supply by Central Banks of western economies.

This fault line could lead to greater problems for the Indian economy going forward as at some point the exchange rate will have to revert to the formula rate. This could mean a greater depreciation of rupee going forward, unless inflation rates in US start going up. 

One of the scenario's which could remove this fault line could be the following,

1. Phase 1: Fall in rupee value due to outflow of money from India, due to improvements in the economy of US. 

2. Phase 2: Increase in inflation rates in US due as a consequence of the improved economic conditions

3. Phase 3: Fall in rupee value could lead to an increased export competitiveness (assumption being the competitiveness is not wasted into salary increases but for making investments) which could lead to investments being made by industries and a fall in inflation

4. Phase 4: Fall in inflation rates in India and increasing inflation rates could lead to the relationship being again followed

If the Phase 3 outlined above does not happen then we could see a painful adjustment within the economy leading a crisis.