Money is not an organic creature but its value keeps changing with the society and its economic conditions. One rupee in 1947 is not the same as one rupee today, both in terms of appearance and purchasing power.
The value of a country’s currency is linked with its economic conditions and policies.
“The value of a currency depends on 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,” says Pramit Brahmbhatt, chief executive officer, Alpari Financial Services (India), a foreign exchange brokerage.
Income levels influence currencies through consumer spending. When incomes increase, people spend more. Higher demand for imported goods increases demand for foreign currencies and, thus, weakens the local currency.
Balance of payments, which comprises trade balance (net inflow/outflow of money) and flow of capital, also 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 imports. This strengthens the local currency,” says Kishore Narne, head, commodity and currency research, Anand Rathi Commodities, a brokerage house.
Another factor is the difference in interest rates between countries. Let us consider the recent RBI move to deregulate interest rates on savings deposits and fixed deposits held by non-resident Indians (NRIs). The move was part of a series of steps to stem the fall in the rupee. By allowing banks to increase rates on NRI rupee accounts and bring them on a par with domestic term deposit rates, the RBI expects fund inflows from NRIs, triggering a rise in demand for rupees and an increase in the value of the local currency.
The RBI manages the value of the rupee with several tools, which involve controlling its supply in the market and, thus, making it cheap or expensive.
“Some ways through which the RBI controls the movement of the rupee are changes in interest rates, relaxation or tightening of rules for fund flows, tweaking the cash reserve ratio (the proportion of money banks have to keep with the central bank) and selling or buying dollars in the open market,” says Brahmbhatt of Alpari.
The RBI also fixes the statutory liquidity ratio, that is, the proportion of money banks have to invest in government bonds, and the repo rate, at which it lends to banks.
While an increase in interest rates makes a currency expensive, changes in cash reserve and statutory liquidity ratios increase or decrease the quantity of money available, impacting its value.
In the modern economy, governments print money based on their assessment of future economic growth and demand. The purchasing power of the currency remains constant if the increase in money supply is equal to the rise in gross domestic product and other factors influencing the currency remain unchanged.
How will weaker rupee hurt the economy?
A weak currency will make imports more expensive . Normally, theory suggests this should lead to a curtailing of imports. However , given the fact that some of India’s major import items, like crude oil, are immune to price changes, the theory does not quite apply in this case.
What is current account deficit (CAD)?
The CAD is effectively a measure of the amount of net capital inflows from abroad that an economy depends on, whether in the form of borrowings or investment.
What impacts widening of CAD?
Two factors have been blamed for widening of CAD. One is the import of gold. India is one of the largest consumers of gold and the heavy import of gold widens CAD as the government has to provide for dollars for every ounce of gold imported. The other factor is crude oil imports . India imports more than 75% of its crude oil requirement . A slowdown in inflows from foreign investors also leads to a weak currency. At a time when the rupee is depreciating, foreign portfolio investors are wary of investing in India since any rupee income they earn could get eroded by a higher exchange rate when they want to take back that income out of India.
Thus, a sort of vicious cycle is triggered as the rupee dips, FIIs tend to pull out money and that in turn makes the rupee dip further. This can be offset by boosting longer term capital flows from abroad like FDI or overseas borrowings.