In today’s world, currency FX rate plays an important role in trade. Major export countries purposely keep their exchange rate low to boost exports and remain competitive among other. This post is to understand the impact of currency devaluation and how to classify currency as overvalued or undervalued.
What is currency devaluation?
Countries purposely keep their currency value low to remain competitive in international trade. Devaluation helps to encourage export and make imports costly.
For example just assume,
1 USD = 60 INR
US made pant cost = 30$
After import, pant cost in India = 1800 INR (60*30)
Now INR devalued to 70 (1 USD = 70 INR)
After import, pant cost in India will be more costly = 2100 INR (70*3)
This will encourage the domestic consumers in India to use local made pants because it will be cheaper than the imported.
Now look in the terms of export
1 USD = 60 INR
Indian made pant cost = 600 INR
Same pant will look more cheaper in International market = 10$ (quoted in $ because of international market)
Now INR devalued to 70 (1 USD = 70 INR)
Indian pant looks more cheaper in international market = 8$
Now consider another example in Thailand
Thailand made pant cost = 700 THB (Assume 1 USD = 35 THB)
Thailand pant cost in international market = 20$.
Now if Tunisian country wholesale company wants to import pant from other country because of the local demand. When they look in international market they feel Indian made pants are cheaper (8$) compared to Thailand (assuming quality of both countries are same). Now Thailand have two options either devalue the currency or find some other alternate product for export to remain competitive in international trade.
What is the impact of currency devaluation? Does it impact the world economy?
Answer is pretty simple, “YES”
Before getting into that, let we just recap the history of World War II which provides more insights about impact of currency devaluation.
“Money plays the largest part in determining the course of history”.
France economy was in bad shape especially after World War I (WW1) and not able to settle the debt which they accumulated in WW1. They devalued the currency purposely to remain competitive among other countries which resulted in trade surplus for France and trade deficit for other countries in Europe (UK and Germany) and rest of the countries as well. During that time, entire world currency system was based on gold based standards which resulted in more inflow of gold to France. Other countries in WW1 were also in debt and they also need to devalue the currency to remain more competitive in the world trade. Many countries moved out of gold standards based currency system as they were running out of gold which lead to great economic distress to other countries. Germany was in more terrible state as they were in hyperinflation. They moved out of gold standard and printed more currency notes. Most of the country’s currencies became worthless. Revolt began in many countries, because citizen were not getting basic needs like food, clothes etc. which resulted in WW2 (Germany invaded Poland). Supremacy among the country is not only the reason for WW2, currency devaluation (Currency war) is also one of the reason for WW2. Actually currency devaluation started to remain competitive in world trade but it went in other way around people lost faith in currency and trade became stagnant. Everyone knows the impact of WW2 and the economic state of the countries after the war. After the WW2, all countries agreed to keep stable exchange rates based on Bretton Woods agreement and IMF. From the above, bloggers can understand the impact of currency devaluation.
1 USD = 67 INR (approximately)
1 USD = 6.4 Yuan (approximately)
Is it really 1 USD buys 67 INR worth of goods in trade? Answer is “NO”. Then why that much difference in exchange rate. To understand this we need to look at three important terms
- Purchasing Power Parity (PPP)
- Real Effective Exchange Rate (REER)
- Nominal Effective Exchange Rate (NEER)
What is Purchasing Power Parity (PPP)?
Purchasing power parity is a measure of currency purchasing power i.e.) how much unit of currency buys set of goods compared to other currency. PPP defines how much adjustment needs to be made on the exchange rate between two countries.
For example to live a life for a day, citizen needs basket of products like water, vegetables, milk, egg, bread etc. and to buy these they need currency.
Country A currency requires 100 units to buy basket of goods
Country B currency requires 50 units to buy same baskets of goods means Country B currency is stronger to country A.
1 unit of Country B = 1.5 unit of country B.
Replace A with USD and replace B with SGD
1 USD = 1.5 SGD
PPP is crictized by many economist because you cannot find same basket of goods across two countries and also it never includes inflation, taxes, transportation cost etc. For example in India, people don’t like burgers, pizza and they eat this occasionally but in US it is not like that, burger is common for meal. PPP also does not include inflation, labor cost, operating cost and trade barriers. Labor cost and operating cost of India is cheaper in India compared to US.
Calculating the exchange rate based on the buying power of the currency is usually called as PPP Exchange Rate. Based on this, economist predict whether currency is overvalued or undervalued.
Using PPP, economist developed a model called Big Mac Index which is comparing the price of Big Mac burger across the various countries.
As per Big Mac Index, rupee is undervalued around 50-60 % and its value should be 1 USD should be in the range of 25- 35 rupees. But the current exchange rate is around 1 USD = 67 INR.
By the survey using PPP, INR is world third most undervalued currency.
Before getting into NEER and REER we will look into Nominal Exchange Rate and Real Exchange Rate.
In layman terms, nominal exchange rate is the rate which we see in FX market. It will say how many units of currency can be exchanged for another currency without considering the fact of purchase power of the local and foreign currency. In floating exchange rate mechanism it is simply based on demand-supply of the local currency against foreign currency.
1 USD = 67 INR
1 USD = 46 PESO
Real exchange rate is the rate which considers PPP along with inflation of two countries. To understand in layman term let us look at an example below
Let us assume a basket of goods like rice, wheat, oil, bread, egg etc.
Country A requires 10000 unit of currency to buy basket of goods.
Country B requires 100 unit of currency to buy basket of goods
Based on PPP, we can say 1 unit of currency B is equal to 10 unit of currency A.
1 unit of country B’s currency = 100 unit of country A’s currency
From the above you can see Country B currency is stronger than A because of the buying power.
Country A’s inflation is 11% (just assume)
Country B’ inflation is 1%
Net difference of inflation between two countries = 10 %
After inflation adjusted, real exchange rate is
1 unit of country B’s currency = 110 unit of country A’s currency
This is how real exchange rate is calculated i.e.) PPP is adjusted with inflation.
If nominal exchange rate is higher than real exchange rate then that country’s currency is called undervalued.
If nominal exchange rate is lesser than real exchange rate then that country’s currency is called overvalued.
Identifying basket of goods to calculate PPP is always difficult because necessity of the goods differs among people in different regions. Hence this methodology is always crictized and economist argue these model of calculating undervalue or overvalue of the currency prediction is wrong.
Next model which economist is using to predict undervalue or overvalue is that NEER and REER.
NEER means Nominal Effective Exchange Rate. NEER is an index that measures the local currency against weighted average of several foreign currencies, which usually will be the currency of trading partner countries. An increase in the NEER means appreciation of the local currency against foreign currencies.
REER means Real Effective Exchange Rate. REER is an index which is NEER, adjusted with inflation. An increase in REER means local currency is getting appreciated against foreign currency which in turn exports becomes expensive and imports becomes cheaper.
Reserve Bank of most of the countries will calculate the NEER & REER index and publish it. As of now we saw about currency devaluation, impact of currency devaluation, nominal exchange rate, real exchange rate, PPP, NEER and REER.
Now let’s go back to the basics and find whether Indian currency (INR) is overvalued or undervalued as per today’s nominal rate.
As per Big Mac Index, INR should be traded in the range around 25-35
1 USD = 25-35 INR
But economist argue that this model of prediction is incorrect because Indian people taste is different. Hence to remain competitive, burger remains cheap in Indian Market. Might be correct!
But I went in other way around to find PPP for INR against USD. Let us compare New York and Bangalore because both the cities are most costly city in the respective countries.
Have a look at the below site which compares the prices of New York and Bangalore. http://www.numbeo.com/cost-of-living/compare_cities.jsp?country1=India&city1=Bangalore&country2=United+States&city2=New+York%2C+NY&displayCurrency=USD
You would need around 7,222.74$ in New York, NY to lead the same standard of life that you can have with 85,000.00Rs (1,271.87$) in Bangalore (assuming you rent in both cities).
By looking at this cost of living data, you can easily say Rupee is undervalued compared to USD. Even if you add inflation of both countries (India and US) still rupee value is undervalued and more or less it is getting closer to Big Mac Index.
As per PPP analysis we can clearly say INR is undervalued against USD.
Now let’s look at REER and NEER index which RBI is publishing periodically to identify whether INR is undervalued or overvalued.
If you look at the above data it is just index value and it not exact exchange rate against any specific currency. To get value against specific currency we need to do few calculation which is shown below.
Six Currency trade based index value for REER = 120.82
Nominal rate of USD against INR = 67 INR
Exchange Rate based on REER = Nominal * (REER/100)
Exchange Rate based on REER = 67 *(120.82/100) è 80.4
As per the above calculation you can see INR is overvalued. INR should be in the range of 80 against USD to remain competitive in international market. Not too sure how India is calculating inflation because there is huge difference among cities and villages in India.
Conclusion is that rupee is undervalued by PPP (should be around 25-35 against USD) and overvalued by REER (should be around 80 against USD).
PPP is available for most of the currencies in the world even third party vendors like Bloomberg is calculating its own value and publishing it. REER and NEER is getting published by most of the country central bank and IMF. By looking at PPP and NEER/REER we can calculate whether currency in overvalued or undervalued.
Most of the countries, keep their exchange rate undervalued to remain competitive in international market. Too much of depreciation always cause panic in international market because of that reason only when China depreciates the currency entire world market was crashed. Hopefully history won’t repeat again and there is a quote from Karl Marx which is very apt for this post. And this marks end of this post as well!