Value of Indian Rupee vis-a-vis other global currencies (i.e. Exchange Rate) is tracked by many and is a very important variable impacting various asset classes and the economy. There are a host of factors that influences the exchange rate – like inflation, current account deficit (CAD), fiscal deficit, etc. However, one common factor which is the foundation & ties all other key variables together is the simple law of demand and supply. When demand for US dollars in India exceeds supply of dollars in India, Indians have to pay a higher price for the US dollar to acquire it. Conversely, if India generates a lot more US dollars than it demands, we have a surplus of US dollars and the price we need to pay for US dollars falls as a consequence. Let us explore the impact of each key factor affecting exchange rate:
Inflation: Countries with high inflation exhibits a depreciating currency value as its purchasing power decreases relative to other currencies – e.g. USD & INR – where we see that INR has depreciated over the years mainly because of higher inflation in India vis-à-vis US.
Interest Rate Differential (IRD): IRD in two currencies offer arbitrage opportunity of making money. To maintain equilibrium, value of currency in higher interest rate offering country depreciates vis-à-vis other.
Current Account Deficit (CAD): CAD is excess of import payments over export earnings. Thus, a higher CAD means higher net outgo of USD, thereby increasing its demand and hence depreciating the rupee.
Capital Flows: Increase in FII & FDI inflows on account of better long term prospects of India increases the supply of dollar into the economy & thereby enables rupee appreciation. The reverse is the case when the FIIs pump put money from Indian market.
Fiscal Deficit: Fiscal Deficit is the excess of government expenditures over its receipts. Such deficit could either be funded through domestic borrowings or foreign borrowings. In case of latter, demand supply equation of US Dollar comes into the picture and thereby impacts the exchange rate. Note that the Central Banker (RBI) steps in to either buy or sell the dollar, when there is too sharp a mismatch between demand and supply – just as a market maker does in stock markets. The Central Banker can only smoothen the flow, but can rarely change the direction of movement.