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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 2 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 3 / 20
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
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90
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Real and Nominal Index for INR Against Basket of Currencies
Nominal Appreciation Real Appreciation
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 4 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 5 / 20
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?
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 6 / 20
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?
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 7 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 8 / 20
Similarity In US Equity and Carry Trade
Payoffs from US equity and INR carry are highly correlated
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−10
010
20C
arry
Pro
fits
(%)
1015
2025
US
PE
2001m1 2005m1 2009m1 2013m1 2017m1
US PE Ratio Carry Profits (INR /USD)
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 9 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 10 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 11 / 20
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 !
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 12 / 20
Currency and International Trade
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 13 / 20
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?
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 14 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 15 / 20
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.
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 16 / 20
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.
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 18 / 20
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
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 19 / 20
Thank You !
Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, 2017 20 / 20