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Currency Valuation and Does Value Matter?

Dr. Apoorva Javadekar

CAFRAL

November 7, 2017

Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 1 / 20

Overview of The Talk - Two Themes in FX

Asset Pricing Framework to Value INR / USD

Looks at the currency as an Asset Class

INR has a similar risk profile as US equities

(Non) Dependence of India’s trade on Exchange rate

Irrelevance of Real Exchange rate

impact of Dollar Invoicing on Trade


Real Exchange Rate & INR Valuation

Real Exchange Rate (RER) - A predominant measure to valuecurrency

∆RER︸︷︷︸Real Appreciation

= ∆NER︸︷︷︸Nominal Appreciation

+ (πindia − πusa)︸︷︷︸Inflation Differential

∆ RER gives net change in country’s trade competitiveness

RER is a trade-specific measure

ignores the importance of capital flows through equity and bonds

ignores the fact that currency is itself an asset class


Historic View of INR Against Basket of Currencies

Real appreciation and nominal depreciation

Divergence due to high inflation (2007-2013) and strong nominalperformance (2014-2017)

50

60

70

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90

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130

01-2

000

07-2

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07-2

017

Real and Nominal Index for INR Against Basket of Currencies

Nominal Appreciation Real Appreciation


Carry Profits in INR / USD

Carry Trade: Invest in Indian risk-free assets to earn extrainterest as compared to US riks-free rate

Carry Profits

πcarry = (iindia − iusa)︸︷︷︸Interest Profit

− (st+1 − st)︸︷︷︸INR Depreciation

iindia, iusa: risk free interest rates in India and USAst = INR Per USD

Strategy is risky as st+1 unknown at time t

Risk Averse Investors =⇒ Require risk-premium to hold carrystrategy

E [πcarry] = Risk Premium > 0


Road map for Asset Pricing Perspective

Existence of Carry Profits is not an indication of currencymispricing

Long-Term carry profits reflect risk premium required by theinvestors.

Two Objectives:Compute Carry profits for INR - USD pair

Is the quantum of carry profits reasonable when viewed as riskpremium?

What is the risk in the currency?


Historical Carry Profits in INR / USD

Convert 1 USD to INR in January 2004 or 2008 or 2012. What NERgenerates equalized returns across countries for various points in time?


Carry Profits to Risk Premium

Sustained carry profits in INR / USD

For 2004, Zero Carry Profit Rate = 90 INR / USD

=⇒ Annual profits ≈ 3%

Can we justify the carry profits as Risk - Premium?

Only if we can find a source of risk that investors price


Similarity In US Equity and Carry Trade

Payoffs from US equity and INR carry are highly correlated

−20

−10

010

20C

arry

Pro

fits

(%)

1015

2025

US

PE

2001m1 2005m1 2009m1 2013m1 2017m1

US PE Ratio Carry Profits (INR /USD)


INR and US Equity - Common Drivers of Valuation

Both US equity and INR Carry are inversely linked with US VIX

1020

3040

5060

VIX

−20

−10

010

20C

arry

Pro

fits

2001m1 2005m1 2009m1 2013m1 2017m1

INR/USD Carry Profits US VIX

INR Carry Trade − VIX

1020

3040

5060

VIX

1015

2025

US

PE

2001m1 2005m1 2009m1 2013m1 2017m1

US PE Ratio US VIX

US PE Ratio and VIX


FX Risk Premia - US Consumption Risk View

Equity risk premium: equity performs poorly exactly wheneconomic fundamentals and investor’s consumption is low

=⇒ US investors require risk-premium to hold foreign currencieswhich do not hedge their consumption or income risk.

Evidence from Lustig & Verdlhan (AER, 2012): Carry profitsincrease with the correlation between currency returns and USconsumption growth

Et(πicarry) = βic︸︷︷︸

exposure to US Risk

× λc︸︷︷︸price of risk = 2%-3%

My calculations suggest that βindia = 1.02 for aggregate USconsumption and βindia = 2.17 for non-durable goodsA reasonable approximation to πcarry ≈ 2− 3% for India


Conclusions on Currency Valuation

Failure of Uncovered Interest Parity (UIP) or equivalentlyexistence of carry profits merely reflect the risk-premium on INR

Real exchange rate (RER) is a poor measure as it considers onlytrade competitiveness

INR earns an annual risk-premium of 2%-3%, which is areasonable approximation given US consumption β to INR returnsof 1.02

=⇒ INR fairly priced !


Currency and International Trade


Evaluating Real Exchange Rate?

RER is a trade-weighted index of Bilateral exchange rates

∆RER =

N∑i=1

[∆NERi − (πindia − πi)]× Trade Weighti

RER Appreciates if

Either NER appreciates against country i

Or India’s inflation is higher than country i

Does changes in RER matter for Trade?

Equivalently, does Bilateral Exchange Rates matter?


Two Facts About Trade Pricing

India’s 85% trade is Invoiced in USD

Table: India’s Trade Invoicing Pattern

Exports % Imports %Currency 2009 2014 2009 2014

US Dollar 84.06 86.94 86.06 83.19Japanese Yen 0.48 0.09 2.3 1.36Euro 10.85 7.11 9.82 9.18

Quoted Dollar Prices are sticky (Gopinath, 2015)

Exporters change Dollar Prices only once in a year on average


What Are the Consequences For Trade?

USD Invoicing + Sticky USD prices =⇒ In the short-run

Export volumes almost de-linked from INR / USD movementBut Exporter’s margins move with INR / USDImports-driven inflation could be substantial

Imports Driven Inflation - Some EvidenceA 10% depreciation of Turkish Lira relative to trading partners leadsto 9.3% increase in imports pricesA 10% depreciation of USD relative to it’s trading partners leads to4.3% increase in imports pricesIndia’s Dollar invoicing share is far higher than Turkey’s (around60%). Hence we are more exposed to imports inflation risk.


Importance of Bilateral Rates For Exports?

INR

FC=INR

USD× USD

FC

Exports can take a hit even with stable USD prices if country icurrency depreciates against USD

But INR and it’s EM trading partner currencies are positivelycorrelated against USD

=⇒ When INR appreciates against USD, partner currenciesappreciate too

We export roughly 22% to East Asia and 20% to Middle East

No impact of INR / USD movement on exports to USA as USDcost is stable in the short run

And we export 15% of our exports to USA

Limited Role of Bilateral Rates or RER for Exports in Short-run!Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 17 / 20

INR / USD Impact on Exports in Long-Run?

In the long-run, exporters will adjust USD quoted prices to restoretheir margins

Decreased demand for Indian exports

But INR appreciation in the long-run leads to

More foreign capital to flow in the countryLowers the cost of foreign technologyHence improves the productivity and lower the cost of production

Hence Long-run effect on exports is not necessarily negative.


Conclusion

Import and Export Volumes are de-linked from exchange ratemovements in the short-run

But INR / USD movement causes a significant imports-driveninflation

”INR appreciation to hurt exports” is a empirically and theoreticallyirrelevant a tagline in short-run

In the long-run, USD quoted prices and productivity move inopposite direction and effect on exports volume uncertain


Thank You !


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