Key Factors Influencing Rupee vs. Dollar Value

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.

What Is an Exchange Rate?

An exchange rate is the price at which one currency can be exchanged for another. For example, if 1 US dollar equals ₹83, then the value of the rupee against the dollar is ₹83. This number is called the rupee vs dollar value, and it keeps changing every day.

These changes happen because of many reasons, like inflation, interest rates, and how much we import or export. In simple words, the value of a currency depends on how strong or weak a country’s economy is compared to others. Understanding the factors influencing the exchange rate helps investors make better decisions—especially when investing in global markets or buying imported goods.

Factors Influencing the Exchange Rate

The value of a currency, like the Indian rupee, changes every day when compared to others like the US dollar. This change is known as the rupee vs dollar value. Many things affect this rate — some are economic, while others are political or global in nature.

These factors influencing the exchange rate decide whether the value of the rupee against the dollar will go up or down. Some of the major factors affecting rupee value include inflation, interest rates, public debt, and the country's trade balance. When these factors are in good shape, the rupee strengthens. But if they are weak, the rupee vs dollar rate may fall, making the rupee weaker in comparison to the dollar.

1. 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.

2. 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.

3. 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. 

4. 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 bonds. Thus, inflation will go up, and currency valuation will go down.

5. 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.

6. 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.

7. 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.

8. Fiscal Deficit

When government expenditure is unchecked, the impact is immediately evident in the fiscal deficit. 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.

Recent Trends in INR vs USD

Here are some of the recent developments that have affected the rupee vs dollar value:

1. Rupee Stability Post-COVID
   After the pandemic, the value of rupee against dollar remained mostly stable, supported by RBI interventions and foreign investment flows.

2. Rising Interest Rates in the US
   The US Federal Reserve has raised interest rates multiple times. This attracts global investors to the US, which increases the demand for dollars and weakens the rupee.

3. Foreign Investment in India
   Strong FII (Foreign Institutional Investor) inflows into Indian markets have helped the rupee gain value at times, showing the impact of foreign money on rupee vs dollar exchange rate.

4. Oil Prices and Imports
   As India imports a large amount of crude oil in dollars, rising oil prices increase the demand for dollars and hurt the value of the rupee.

5. Global Uncertainty
   Events like wars or financial crises lead investors to prefer the US dollar, affecting the exchange rate unfavourably for the rupee.

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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Frequently Asked Questions

1. What is the impact of the economy on the exchange rate?

A strong and growing economy usually means a stronger value of a currency. When India’s economy performs well, it attracts foreign investments, increasing demand for the rupee and improving the rupee vs dollar value. On the other hand, if the economy slows down or faces issues like inflation or low growth, the value of rupee against dollar may drop. So, the overall health of the economy plays a key role in determining the exchange rate.

2. How does inflation affect exchange rates?

Inflation is when prices of goods and services rise. If India’s inflation is high, the value of a currency like the rupee drops, because it loses its purchasing power. Investors avoid currencies with high inflation, which weakens the rupee vs dollar rate. But if inflation is low and stable, it supports a stronger value of rupee against dollar. So, inflation is one of the most important factors influencing the exchange rate.

3. How do exports affect exchange rates?

When India exports more goods and services, it earns more dollars. This increases the demand for the rupee, which strengthens the rupee vs dollar value. On the other hand, if imports are much higher than exports, the country spends more in dollars than it earns, weakening the rupee. So, export performance is one of the key factors affecting rupee value and plays a direct role in improving the country’s exchange rate.

4. How do interest rates affect exchange rates?

Interest rates are the returns investors get from keeping money in a country. Higher interest rates in India attract foreign investors who want better returns. This increases demand for the rupee and improves the rupee vs dollar rate. But if the US or other countries raise their interest rates, investors may move funds there instead, weakening the rupee. So, interest rates are a key factor influencing the exchange rate and the overall value of a currency.

5. What is a current account deficit?

A current account deficit happens when a country spends more on imports, foreign travel, or other services than it earns from exports and investments. In simple terms, it shows that the country is using more foreign currency than it brings in. This increases the demand for dollars and weakens the value of the rupee against the dollar. A rising deficit is one of the major factors affecting rupee value and puts pressure on the exchange rate.

6. Does Rupee appreciation/depreciation impact the stock markets?

Yes, it does. When the rupee appreciates (gains value), importing companies benefit as they pay less in dollars. However, exporters may earn less. When the rupee depreciates, exporters benefit but import costs rise, which can increase inflation. These changes affect the profits of listed companies and overall investor sentiment, causing stock prices to move. So, changes in the rupee vs dollar rate can directly impact the Indian stock market, especially sectors like IT, oil, pharma, and FMCG.