The Rupee struck an historic low in last few days against the US dollar touching 85.10 after a constant decline in the past weeks. This trend has received concern from the policymakers, economists and other members of the society. There are several causes for this depreciation which are as follows: To analyze it, let us first understand all the factors that go into this and how they relate to the economy overall.
Trade Deficit and Imports and Exports Pattern
The primary cause of this decline has been pegged on the trade deficit of India. In a situation where a country has more import that is it purchases more from other countries as compare to its exports that is selling to other countries, it has a trade imbalance known as trade deficit. India has been importing more than it exports and this has resulted to more demands of foreign currencies especially the dollar. This higher demand for the dollar, exerts pressure on the rupees and thus will be weaker than the dollar.
Foreign Investment and Capital Outflows
Capital flows or foreign investments are key determinants of fixed foreign exchange rates in the global market. It also adds to another loss seen from the side of Indian business and economy that is the capital flight as whenever FII or any foreign investor, pulls out investment from Indian stock market, it means withdrawal of capital. Things like Increase in sales of Indian stocks by foreign investors have also been deemed as a reason for rupee declining in recent times.
US Federal Reserve Policies
The value of rupee also depends on the policies of US Federal Reserve. This has resulted from the Federal Reserve having continued to set a higher tone on the benchmark interest rates primarily pushing up the dollar. This means where the US dollar rises, other emergent market currencies such as the rupee tend to decline. The expectation of fewer rate cuts by the Federal Reserve in the coming years has further bolstered the dollar's strength.
Economic Growth and Investor Sentiment
Investor interest has been affected due to slower than expected economic growth of India. Low growth rates and a deleveraging merchandize trade balance have sparked investors’ apprehensions to invest in the country instead of the Indian economy. This has led to low foreign investments and in turn continues to cause a decline in the value of the rupee.
Global Economic Factors
Global economics has also it role when it comes to determining the value of the Rupee. The overall improvement in the US economy especially through high GDP per capita income and low unemployment rates has contributed in the stability of the dollar. Additionally, geopolitical tensions and uncertainties in global markets can lead to a flight to safety, with investors flocking to the US dollar as a safe-haven currency.
Reserve Bank of India’s Interventions
In a measure to tame the rupee, the Reserve Bank of India (RBI) has time and again come to the currency market with interventions. To avert the rupee's decline and sustain currency market stability, the RBI has started selling dollars. But these interventions have not been sufficient to go up against the general economic forces that negatively influence the rupee.
Impact on the Indian Economy
There are various implications of the depreciation of the rupee in the Indian economy. On the positive side, a weaker rupee can boost exports by making Indian goods and services cheaper for foreign buyers. But it also results to high cost of imports that tend to fuel inflation in the economy due to their nature. At the same time, a lower value of the rupee can exacerbate the problem of external debt, as the services of foreign credits become costly.
What is the Exchange Rate?
Exchange rates are the market price of one nation’s currency for another nation’s currency. This is an important parameter of the health of a nation’s economy and has a key function in both export/import and investors. Many elements come into play when it comes to determining exchange rates such as trade of the specifically foreign currency, interest rate, inflation and political stability.
Types of Exchange Rates
- Fixed Exchange Rate: The foreign exchange value of a nation's currency is either pegged to gold or to another foreign currency, such the dollar, under a fixed exchange rate system. In the framework of this type the government or the central bank aims at having direct operations in foreign exchange market so that to keep the currency range within a small margin.
- Floating Exchange Rate: In a system of exchange rate flexibility, the basis for valuation of a certain country’s currency is supply and demand. It is unregulated, in a sense that there is no direct government or central bank interference with it, it rises and falls according to the state of the economy, investor opinion, or events happening around the world.
- Managed Float: A managed float, or dirty float, is a mix of fixed and floating exchange rates in which a currency float in the market but the government or the central bank have a mechanism for influencing the direction of the float and in most cases, attempt to push the currency higher in value.
What determines the exchange rate?
Exchange rate is simply the ratio between one currency and another and this form of alignment is established based on several factors that depict the strength or otherwise of countries’ economies. It is important to get an understanding of all these determinants towards appreciating the fundamentals of international finance and trade.
Supply and Demand Dynamics
Fundamentally, the supply and demand for various currencies influence the exchange rate. When a currency is in high demand, its value increases relative to other currencies, and vice versa. Variables that affect this demand include balance of trade, foreign investment and economic performance.
Interest Rates
The interest rates set by a country’s central bank has a central position in the determination of exchange rates. People are willing to invest more in a country that paying more in interest so this creates more demand for that currencies. On the other hand, interest rates can lower imply that there will be more depreciation of currency since investors will look for other better returns to maximize.
Inflation Rates
For inflation directly affects the purchasing power of any given currency. The purchasing power of a country having low inflation is stable and, therefore, their currency records an improvement. But with high inflation, there is reduction in value of the particular currency plaguing it to depreciation. This really can affect the exchange rates between two nations especially when differing in their inflation rates.
Economic Indicators
They include factors such growth rate in gross domestic product, employment levels, and level of industrial production affect the investment environment. According to economic growth theory and actual evidence, high economic performance increases the level of foreign inflows in the economy, inevitably driving up the demand and consequently the value of the home currency.
Political Stability and Economic Performance
Political stability and good economic policies create confidence to investors and encourage foreign direct investors. That is why, comparing them with other currencies, the notes and coins of countries with stable governments and long-term economic policies are getting more valued. On the other hand, existence of political instability and economic risk results to currency devaluation.
Market Speculation
Another relevant actor in the foreign exchange market is speculators bearing the responsibility for exchange rates’ formation. For this reason, differences in the behaviors of different currencies can be attributed to their views and forecasts regarding the likely shifts in currency pair values in the short run. If speculators expect a particular monetary item to rise they will demand more of it leading to a higher value.
Determinants of Demand for Rupee against the Dollar
The forex relation between the Indian Rupee (INR) and the U.S. Dollar (USD) depends on factors that define the demand out-rightly. It is important to have these factors in mind when struggling to resolve issues connected with the fluctuation of currencies and international trade.
- Trade Balance: Trade balance gives direction for the demand for rupee in India in as much as exports affect the same in terms of demand. A trade surplus or/export exceeding imports put pressure on the demand for rupee in the foreign market since the foreign buyers need to pay through rupee for the imported goods and services. On the other hand, a trade deficit works to boost demand for dollar due to Indian importing more of goods and services paying through the dollar.
- Foreign Direct Investment (FDI): Large volumes of FDI in India increase the purchasing of the Indian Rupee on currency markets. If foreign investors invest in Indian businesses these turn their dollars into rupees hence enhancing demand for the local currency. In the deficits case, FDI decrease can reduce the demand for rupee hence depreciation.
- Interest Rates: Interest rate differentials between India and the United States impact the demand for the rupee. If the interest rates are higher in India compared to US then more investors looking for better returns will demand the rupee. On the other hand, increased US interest rates make foreign investments flow to the US hence demand for dollars.
- Inflation Rates: Stable inflation rates in India improve the purchasing power of the rupee in the foreign markets thus demand for the issuance of the rupee increases. The result is high inflation which reduces people’s purchasing power, discourages investments hence lowering demand for the rupee.
- Economy and Politics: Political and Economic stability of a country is Favorable for investors, where by it encourages international investors to invest hence demanding the rupee. Political instability or economic uncertainty can lead to capital flight, where investors move their funds to safer economies, increasing demand for the dollar.
- Remittances: India gets a large sum of money from Non Resident Indians working in foreign countries. These remittances which are normally repatriated in rupees create demand for the local currency. The movement in the figures of remittance also tends to affect the demand for rupee with respect to dollar.