About ‘Exchange Rate’ of a currency:
The exchange rate of the currency of a country in relation to the currency of another country depends on the comparative trade advantages and economic strengths of the countries. If one US dollar is equal to 45 rupees, it simply means that in the US, if a dollar fetches 45 oranges while in India, a rupee would fetch only one orange of equivalent size and quality. Live Currency Rates In India
Just like any other commodity, the currency of any economy is based on dynamics of supply and demand, and its value depends on trading in currency exchanges all over the world. Higher the demand for a currency on an exchange, the stronger it becomes and vice versa. However, for currencies like INR which are not traded on exchanges, the value depends on capital inflows in the country.
Appreciation & Depreciation of currency:
A currency appreciates means its value has increased in relation to another currency. A currency depreciates means its value has decreased in relation to another currency. Eg. If 1 $ costs Rs 45 and if it now costs Rs 44, this means rupee has appreciated in its value (i.e. instead of Rs 45 you will get 1 $ in Rs 44, this also means the dollar has weakened). Similarly, if 1 $ costs Rs 45 and if it now costs Rs 46, this means rupee has depreciated in its value (i.e. instead of Rs 45 you will get 1 $ in Rs 46, this also means the dollar has strengthened).
Why do currency values fluctuate?
There are many participants in any foreign exchange market. These entities — like banks, corporations, brokers, even individuals — buy and sell currencies everyday.
Here too the universal economic law of demand and supply is applicable: when there are more buyers for a currency than sellers, its exchange rate rises. Similarly, when there are more sellers of a particular currency than buyers, its exchange rate will fall. This does not mean people no longer want money; it only means that people prefer to keep their wealth in some other form or another currency.
Scenario before occurrence of the current financial crises:
We were witnessing a surge of dollar-inflows into India due reasons like strong economic fundamentals and favourable business atmosphere, etc. These dollar inflows can be in the form of Foreign Direct Investment, portfolio inflows (foreign investment in equity), External Commercial Borrowings by Indian companies abroad,
remittances to India by Non-Resident Indians. Since the Indian economy and the Indian stock markets have been on a roll, the capital inflows to India has been pretty strong which has primarily led to the appreciation in value of rupee. This huge influx caused a significant demand – supply gap between the dollar and the rupee. Going by the laws of demand & supply, the rate of the rupee vis-à-vis the dollar, rises.
Due to this exporters were placed at a disadvantage with a rising rupee, since the dollar became weaker. Thus a dollar which fetched Rs. 48 about two years ago today fetched only Rs. 44 eating into the profit margins of exporters (since they earned less on their exports).
At the same time, importers benefit (since they need to pay less for their imports), but our economy was at a stage where we first needed to build our dollar reserves to meet our import payments and so 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).
