Rupee seems fairly valued on a real basis

The Indian Rupee now seems fairly valued on a real effective exchange rate basis.

As such, portfolio flows would be key to the Rupee's direction from current levels with significant downside limited barring significant portfolio outflows.

Note: 

a) A caveat to this analysis is that the BIS uses the wholesale price index (WPI) for India versus consumer price index (CPI) for other countries; as noted earlier by AASSB analysis [refer 14 Feb blog] India's CPI and WPI are quite disconnected at the moment.  As such, India's REER may be understated by using the WPI instead of the CPI.

b) Nominal EERs (NEERs) are calculated as geometric weighted averages of bilateral exchange rates. Real EERs (REERs) are the same weighted averages of bilateral exchange rates adjusted by relative consumer prices. 

Time to look at the yen's real exchange rate

The yen's real effective exchange rate (REER) suggests that the short yen consensus macro trade could be in its last innings.

The yen still seems significantly overvalued versus history on a nominal basis - the monthly average for the yen's nominal effective exchange rate (NEER) in January 2013 was roughly 0.7 standard deviations above its historical average since 1994.

However, as inflation levels in Japan have been much lower than the rest of the world, this has not translated into a loss of competitiveness as measured by the yen's REER (low relative inflation offsets a high nominal exchange rate and vice versa).  The yen's REER in January 2013 was actually 1.4 standard deviations below its historical average since 1994.

The story stays the same even if we look at the yen relative to the Korean won. 

Note: 

a) Nominal EERs (NEERs) are calculated as geometric weighted averages of bilateral exchange rates. Real EERs (REERs) are the same weighted averages of bilateral exchange rates adjusted by relative consumer prices. 

b) Conclusions of analysis may differ based on time periods used; the BIS' broad indices have data from 1994 (used in above analysis).

India's inflation dis-connect

India's January CPI (Consumer Price Index) and WPI (Wholesale Price Index) readings highlight the growing dis-connect between the two inflation measures, and would further complicate monetary policy decision making by the RBI.  This warrants caution on Indian equity markets - expectations of economy boosting lower policy rates (driven by lower inflation) have driven significant foreign investor inflows year to date ($7.8 billion).

Indian policy makers and analysts (present company included) have historically focused on the WPI (in contrast to the CPI focus for most other economies) because of its timeliness and breadth; the new comprehensive CPI (rural and urban) with monthly readings was introduced only in January 2011.

India's January CPI (yoy basis) accelerated to 10.8% from 10.6% in December 2012, and significantly higher than the 7.5% in January 2011.  January 2012 marked the highest reading for CPI inflation over its short history.  By comparison, the January WPI declined to 6.6% (below consensus expectations of 7.0%), from 7.2% a year earlier as well as in December 2012. This was its lowest reading since November 2009.

The divergence is partially explained by a) the higher weighting of food & food products in the CPI (49.7%) versus the WPI (24.3%) as food inflation is higher than headline inflation for both indexes, and b) higher measured food inflation in the CPI versus the WPI (CPI food inflation was 13.2% in January versus only 10.6% for the WPI).

Even the core inflation measures for the two indexes diverge significantly, thought lesser than the headline prints.  The decline in WPI inflation is driven by the moderation in core manufactured products (excluding foods) inflation - core manufactured products inflation declined to 4.1% in January 2013 from a near-term peak of 8.4% in November 2011. Core CPI inflation (excluding food and fuel) remained elevated at 8.4%, having troughed at 8.0% in September 2012.