The exchange rate of the money of a country concerning the money of another nation is contingent upon the comparative trade benefits and financial strengths of those nations. If a single US dollar is equivalent to 45 rupees, it only suggests that at the US, when a buck fetches 45 oranges while in India, then a rupee would fetch just 1 orange of equal quality and size.
The same as any other commodity, the money of any market relies on dynamics of demand and supply, and its value is dependent upon trading in money trades all around the world. Greater the requirement for a money in a market, the more powerful it becomes and vice versa. But for monies such as INR that aren’t traded on exchanges, the value is dependent upon capital inflows from the nation.
Appreciation & Depreciation of money:
A money appreciates means its worth has increased in connection with some other currency. A money depreciates signifies its worth has diminished in relation to some other currency. Eg. If 1 costs Rs 45 and when it currently costs Rs 44, this implies rupee has appreciated in its own worth (i.e. rather than Rs 45 you’ll get 1 $ at Rs 44, this means the dollar has diminished ). Likewise if 1 costs Rs 45 and when it currently costs Rs 46, this implies rupee has depreciated in its own worth (i.e. rather than Rs 45 you’ll get 1 $ at Rs 46, this means the dollar has strengthened).
Why is it that money values fluctuate?
There are numerous participants in almost any foreign market. These entities — such as banks, corporations, agents, even people — purchase and sell currencies regular.
Here also the universal financial law of supply and demand is applicable: if you can find more buyers to get a money compared to vendors, its market rate climbs. Likewise, whenever there are more vendors of a specific money than buyers, its exchange rate will collapse. This doesn’t mean people no longer need cash; it merely suggests that individuals prefer to maintain their riches in another form or another money.
Scenario before incidence of the present fiscal disasters:
We were seeing a surge of dollar-inflows to India due motives like strong financial principles and favourable business setting, etc.. These dollar inflows could be in the Shape of Foreign Direct Investment, portfolio inflows (foreign exchange in equity), External Commercial Borrowings by Indian firms overseas,
Remittances into India by Non-Resident Indians. Considering that the Indian market and the Indian stock markets have already been on a roll, the capital inflows into India has been fairly strong which has mostly resulted in the appreciation in value of rupee. This massive influx caused a substantial demand – supply gap between the dollar and the rupee. Going from the laws of supply & demand, the speed of the rupee vis-à-vis the buck, climbs.
For this reason exporters were put at a disadvantage using a rising rupee, because the buck became poorer. Hence a buck that brought Rs. 48 roughly two years ago now attracted just Rs. 44 eating into the profit margins of exporters (because they earned less in their exports).
At exactly the exact same time, importers benefit (because they will need to pay less because of their imports), but our market was in a point where we needed to construct our dollar reserves to satisfy our import payments and thus that the exporters’ woes were needed to be tackled first.
The Reserve Bank of India (RBI), as the central bank of India, which oversees the foreign exchange (forex) management of this country quite often intervened to ensure that the rupee was adequately propped at a particular rate. This was done to ensure that there are no sudden currency shocks, to protect exporters and importers and above all, to ensure the feeling of ‘national pride,’ which is attached to a stable and healthy currency.
When the RBI intervened to keep the rupee at some weak value, it had to buy the dollar inflows from exporters, from NRIs, from foreign direct investors, from companies that borrow abroad. In any case the sellers of dollars need rupees to conduct their businesses here. The RBI buys or sells dollars via state-run banks to prevent excessive volatility in the forex market and avoid any sharp appreciation or depreciation in the currency. When the RBI purchases foreign currency inflows, the domestic monetary base or money supply or both rises since for every dollar the RBI buys from the market, an equivalent amount of rupees gets injected into the system, adding to excess money in the system or the liquidity overhang. When the RBI buys dollars, it pays for them using freshly printed rupee notes. This leads to greater money supply, higher credit growth and inflation.
And precisely, here comes the catche. As RBI sells more rupees, the money supply increases which means too much money chasing same (or less) number of goods, thereby leading to inflation. So in effect one act of RBI creates another problem. In other words, when the RBI buys dollars from the Indian market, it simultaneously pumps rupees into the currency markets, creating the risk of inflationary pressures. The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. It purchases dollars (to create more demand for dollar) and sells rupees (to increase supply of INR, thereby decreasing its value).
To contain inflationary pressures, the RBI adopts a measure termed as’sterile intervention’ Under this measure, the RBI sells Government of India bonds in the market. With the sale of these bonds, the rupee, which had flowed into the market for buying dollars, is once again sucked out of the market. When the RBI buys dollar-denominated assets, (to create demand for dollars and reduce supply of rupee) it sells rupee-denominated securities to suck the rupees back. But when the RBI has to suck out a whole lot of rupees back, it has to raise rupee interest rates, the Repo rate (the interest rate at which commercial banks borrow for short term from RBI) and the Cash Reserve Ratio (CRR).
This is how the RBI protects the dollar-rupee exchange rates and yet, manages to contain inflation.
Scenario after occurrence of the financial crises:
The sub-prime crises, bankruptcy, sale, restructuring and merger of some of the world’s largest financial institutions caused cataclysmic disruptions in the international stocks and money markets. Imprudent financial decisions, fed by greed and bad luck, have seen global financial markets collapse.
The current financial crises that shook the global financial markets has seen unprecedented bailouts and infusion of dollars into the US economy at a cost of many an emerging market, from where funds have been pulled out to flow back into America.
India, which was till recently having huge capital dollar inflows, now is experiencing flow of dollars outside the country due to selling of more Indian shares than bought (to the tune of over $9 billion), thereby making dollars scarce in India and reduced demand for rupees, simultaneously, as there is increased demand for dollars due to spurt in crude oil prices and the dipped capital inflows.
The dollar prices fell by some considerable amount with respect to most of the currencies. Here in India the rupee rose to around 40-41 a dollar from around the 45 rupees a dollar. There is a lot of panic among the exporters because a weak dollar adversely affects the exporters, especially in the services sector who have all their expenditure in rupees and earnings in dollar.
The growing Indian trade deficit and the large fiscal deficit are also contributing to the fall of the rupee. The higher price of imported goods, especially oil (India is a heavy importer of oil), has also led to an increase in domestic inflation and a fall in the value of the Indian currency. High inflation and a strong growth in the Indian economy have already forced the RBI to raise interest rates.
Example: Consider a firm; say’K applications’ that has a profit margin of 5%. Now’K applications’ bags a contract of 100,000 USD from a big US based firm when the dollar Rupee exchange rate is 45 Rs a dollar. So the profit of’K applications’ would be 5% of 100,000 i.e. USD 5k (= 225k Rs at the exchange rate of 45Re= 1USD) and expenditure which is in usd to inr exchange rate 95k i.e. 4275k Rupees. Therefore,’K applications’ goes ahead with its project and when the project is completed the dollar gets weak and trades at 40 Rupees a dollar. Now’K applications’ has spent 4275k and today despite obtaining the guaranteed 100,000 USD they receive just 4000K rupees and wind up, in effect, paying 275k for creating the program. So weakening of buck is harmful for the exporters.
To describe it with a different instance; Say that exchange rate is US 1 $ 50 INR. When an exporter X earns US $1000 by imitating his goods/services into US, his earnings from Rupee terms is Rs. 50,000. In case the Rupee enjoys to US 1 = 40 INR, afterward in rupee terms that the earnings of exporter will be Rs. 40,000. A drop in earnings regardless of the exports being steady. However, the exporter who’s based in India must invest in INR in India; he’s less cash at his disposal constraining his additional expansion by means of restricting his investment ability.
Importers on the other hand need to spend less to import precisely the exact same thing assume you get a 100$ iPod today you’ll need to pay out only around 4k rather than the earlier 4.5k. This is only one reason why those Oil markets that are mainly the importers keep very large exchange rates by controlling their own currencies.