Foreign Exchange Rate: Solving The Riddle

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Until we live in cave and live like monk, each one of us is concerned about depreciation in rupee which has fallen significantly against the U.S. dollar. It is the common man who is going to get the hit the most as oil prices are spiraling upward, which tends to impact daily life as commuting, becomes costlier.

Why Currency Fluctuate?

The currency fluctuation is a natural outcome of the floating exchange rate system that is the norm for most of the major economies. The exchange rate between two currencies is that rate at which one currency will be exchanged with another currency.

What affects the Exchange Rate?

The value of a country’s currency is linked with its economic conditions and policies. The value of a currency depends on the factors that affect the economy such as imports and exports, inflation, employment, interest rates, growth rate, trade deficit, performance of equity markets, foreign exchange reserves, macroeconomic policies, foreign investment inflows, banking capital, commodity prices and geopolitical conditions.

Let’s look into few of the factors that impact the Exchange Rate:

Macro-Economic Conditions: When global demand for a country’s exports is low, the value of its currency declines. Similarly, if a country imports a proportionately high volume of goods and experiences a trade deficit, the value of its currently depreciates as well.

Monetary policyCentral banks in each country establish monetary policies that cause immediate movements in currency value, and contribute to long-term trends. Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a nation’s central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.

The Bank Interest Rate: An increase in bank interest rates makes a currency expensive while decrease in interest rate results into increase in the availability of currency within the market and eventually decrease in the value of currency. Recently, U.S. federal bank has raised the bank interest rate which is one the major factor of dollar appreciation.

Balance of Payments: Balance of payments, which comprises trade balance (net inflow/outflow of money) and flow of capital, affects the value of a country’s currency. A country that sells more goods and services in overseas markets than it buys from them has a trade surplus. This means more foreign currency comes into the country than what is paid for goods and services. This strengthens the local currency.

The difference in interest rates between two countries: Let us suppose, RBI deregulates the interest rates on savings accounts held by NRI. If we increase the interest rate offered to NRI accounts and bring them on par with resident Indians then RBI can expect fund inflows from NRIs, triggering a rise in demand for rupees and an increase in the value of the local currency.

Political events: In general, fear or uncertainty about the political stability in a country can cause currency depreciation.

The recent depreciation in rupee can be attributed to few of the reasons mentioned below:

  1. The hike in US federal fund rates and thus dollar appreciation
  2. The crash in Turkish currency Lira
  3. The U.S. restriction on buying crude oil from Iran
  4. The Political instability in Venezuela resulted into oil prices going up and Indian being third largest oil importing country has been impacted

2 COMMENTS

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