On 24th January 2014, I blogged about the broad NIFTY levels to keep in mind going forward in the post named-“The Fluttering of butterfly- the effect of currency volatility and equity valuations”.
For everyones benefit- let me quote a relevant paragraph here:
Let us assume that 6300 of 2008 is achieved! This implies 9450, adjusted for 7% inflation over 6 years. But even in that, circumstances the 9450 Rupees of today is not equivalent to the 6300 Rupees of 2008. This is because in 2014 1 Rupee is 25% cheaper than 1 Rupee of 2008, since rupee has fallen recently very steeply. Thus the real amount NIFTY has to rise, to adjust this fall is ~12600.
The thesis is broadly right in ideation but quite way off in calculation. Before proceeding forward- can you spot the mistake here?
Fundamentally the root cause of currency volatility is the result of difference in inflation rates. To dig deeper, let us consider what is the effect of inflation on purchasing power of a currency.
It is a common knowledge that inflation is ultimately debasement of the currency. That is, the purchasing power of a unit of currency has eroded. In simple language- the amount of goods a single unit of currency(1 Re) could buy a unit of time back (1 year ) is more than the amount of goods it can buy today.
Now let us consider the case of two trading countries. When a country imports goods from another country, the importing country receives the goods and in exchange parts with its currency. If the importing country has higher inflation than the exporting country the currency of the exporting country will appreciate making its exports costlier for the importing country.To remain competitive the Central Banks will start printing money to remain competitive. Conversely if the exporting country has higher inflation than the importing country, it can export away its excess liquidity (and hence currency) by investing more in its industry and increasing its exports. To aide in this “averaging” process- it has to export more and more of its currency and import more and more of the stable currency. As a result to aide the asset creation process the exporting country’s currency depreciates to aide other countries to build their factories. Which results in absorption of the capital(due to inflation), absorption of the cheap assets(due to currency depreciation caused by inflation).
In both the cases we see there is an effect of inflation “trading” (import and export) and currency adjustment to reflect capital cheapness/dearness in terms of asset cheapness/dearness.
In the above quoted paragraph I double counted the inflation. 9450 is the level we have to achieve in today’s rupee terms to scale the 2008 highs.
Our highest we have reached till now is 9100.