Know what determines the value of the rupee vs dollar
Know what determines the value of the rupee vs dollar
The Reserve Bank of India governor recently said the central bank will raise the limit on overseas investments by mutual funds when it feels confident that the rupee is stable on a durable basis.
Although the rupee has stabilised after it was under pressure at the start of the Russia-Ukraine war, the RBI is still waiting for the right time to revise the overseas investment limit for mutual funds.
The RBI capped the industry-wide limit for mutual funds at $7 billion on February 2, 2022, and for each mutual fund company at $1 billion.
Let us see who determines exchange rates in India.
Evolution of Exchange Rate Determination in India
The rupee's exchange rate mechanism has undergone a significant transformation.
Before the 1990s, India followed a fixed exchange rate system, with the rupee pegged to the US dollar and other major currencies. The RBI actively managed the rupee's value during this period through currency reserves and monetary policies.
The shift to a floating exchange rate system in the early 1990s, following a near depletion of dollar reserves and comprehensive economic reforms, marked a pivotal change.
Today, the rupee is influenced by various economic and market forces.
Let us look at the factors influencing the exchange rate.
Inflation
The rate at which the general price level of goods and services in an economy rises over time, leading to a fall in the purchasing power of money. It's a critical factor in determining the exchange rate between the rupee and the dollar.
When a country experiences higher inflation than its trading partners, its currency's value typically depreciates. This is because higher prices for goods and services make exports less competitive in the global market.
In contrast, domestic consumers and businesses will likely need more foreign currency to afford imports, increasing the supply of local currency in exchange markets.
Moreover, inflation erodes the value of a currency held as reserves or investments.
Also, the real return value of rupee-denominated assets falls if the inflation rate in India is high. This could make foreign investors move their assets to more stable currencies like the dollar, further pressuring the rupee.
Interest Rates
The policy interest rate, at which RBI lends money to banks, is currently set at 6.5%.
A higher interest rate would mean investors would rush to buy government bonds as the returns would be higher. The rupee will be in more demand and its value will increase.
However, higher rates might discourage people who want to start a business or take a loan to buy a house or car. Economic activity may get stifled and slow down without the flow of capital.
Also, when interest rates are hiked in the US or other countries are raised, there is a greater preference for investing in the bonds of the US or the country that has raised rates.
Current Account Deficit
A current account represents a country's foreign transactions and a. deficit implies that a country is spending more foreign currency on importing goods and services than earning foreign currency via exports.
If imports are higher than exports, the rupee will depreciate. Conversely, if exports are greater than imports, then the value of the rupee will appreciate.
According to the latest data, India's current account deficit (CAD) narrowed to $8.3 billion in July-September vs $9.2 billion in April-June. Accordingly, CAD is at 1% of GDP.
When a country imports goods more than it exports, the value of its currency gets lowered.
In India's case, the import of crude oil and gold constitutes a big factor in the Current Account Deficit.
Public Debt
If a country has a high level of budget deficit and is borrowing to cover this, then it would result in a lower currency valuation.
Public debt is the government’s total liabilities against the Consolidated Fund of India. It is further classified into internal and external debt.
A country with a huge amount of public debt carries a very high risk of inflation.
It must either print new currency to pay off its debts (which again increases inflation) or sell bonds to investors, hence lowering their prices.
If the debt is too large and investors are not confident in the country’s ability to service its debts, then they will not be reluctant to buy these bonds.
Thus, inflation will go up, and currency valuation will go down.
Economic Growth
Foreign investors look to invest in markets that offer stability and economic growth.
Hence it is important for a country to have a stable government and sound economic policies to attract investments.
Hence, a country must have a stable government and sound economic policies to attract investments.
More foreign investments imply higher demand for the rupee, so its price will appreciate.
Dollar Index
The most common benchmark for most currencies is the US Dollar.
A weakening or strengthening of the dollar has a proportionate effect on the dollar-rupee exchange rate.
This is because most of India’s foreign trade and foreign debt is denominated in dollars.
Hence any strength in the dollar index gets proportionately transmitted to the dollar-rupee exchange rate.
The factors influencing the demand for either currency are many and include the state of the economy, the flow of investment money, the difference in inflation, geo-political reasons, etc.
FII Investments
Over the last few years, this has emerged as a key determinant of the value of the rupee.
Normally, healthy foreign institutional investor (FII) flows into India result in the strengthening of the rupee versus the dollar while heavy bouts of selling by FIIs result in the weakening of the rupee.
In FY24, so far, FIIs have been net buyers of Indian securities worth Rs 2,70,879 crores after two years of being net sellers
Hedging pressure in the forward market
Importers or borrowers with an exposure in dollar terms hedge their exposures in the forward market.
When the rupee becomes volatile, importers rush to their banks to hedge their dollar exposure using forwards.
This puts pressure on the dollar demand and further weakens the rupee.
Fiscal Deficit
When government expenditure is unchecked, the impact is immediately evident in the fiscal deficit.
India's fiscal deficit in FY24 is expected to be at 5.9% of gross domestic product, in line with the budget estimates.
The impact of fiscal deficit on inflation depends on the kind of expenditure undertaken by the government.
If the money is spent on productive investments the, the impact on inflation is muted because it takes care of both supply and demand, and the impact might be reduced.
Conclusion
The exchange rate plays an important role in a country’s economy.
While many factors influence its direction, most central banks tend to direct the currency towards a specific target.
While no single factor determines the exchange rate of the rupee, the RBI plays a significant role through market intervention, policy measures and moral suasion.
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