How is the value of currency derived?
Currencies are traded in Foreign Exchange Markets, a global decentralized market for currencies. Simply put, one currency is traded against another currency at a particular rate. This rate at which currencies are traded is known as Currency Exchange Rate. The exchange rate does not remain constant but rather keeps changing. In most countries, the currency’s value is determined by floating exchange rates. In this system, the value of a currency is determined by the basic economic concept of demand and supply. Just like the value of goods change according to their market demand and supply constraints, the value of currencies also fluctuates according to their demand and supply. For example, the pair USD/INR helps in understanding the value of the rupee in terms of US dollars. So, if the exchange rate of the Indian rupee in terms of the US dollar is USD/INR = 81.50 then you get USD 1 if you have INR 81.50. Now, if this rate is going up, it means you will have to shell out more INR to get USD, meaning the rupee is getting less valuable or depreciating. Vice versa, if this rate is going up, you will have to pay less INR to get the same USD, meaning the rupee is getting more value or is appreciating. If you are an exporter, and the exchange rate increases by 1-2%, after having sold the goods, you will get 1-2% more when the customer pays the bill, as against the INR amount that you would have expected at the time of sale. Similarly, if you are an importer and the exchange rate decreases by 1-2%, after having bought the goods, you will have to pay 1-2% more when you settle the bill. Hence, the changing value of the rupee is a piece of daily news.
The economic significance of exchange rates
Apart from providing a rate for the trading of currencies, the exchange rate plays a key role in economists and other stakeholders understanding the value of the country’s currency in terms of another country’s currency. This is because the fluctuation in the exchange rate of the currency happens due to various economical and geopolitical macro factors such as inflation rates, interest rates, recession, current account deficit, government debt, trade terms and negotiations, political stability and government performance etc. Moreover, as the exchange of different currencies takes place in independent exchange markets, the demand for each currency determines its market value. The government or authority of a country exercises no or little control. Of course, the Government has tools to control the exchange rates such as changing policy rates, printing currency or withdrawing the same, major tax reforms, foreign trade policy, and restrictions on foreign remittances, however, these options are more strategic and there is no direct control. So, the change in exchange rates is often linked to the economy, to identify reliable past trends and predict future courses of action.
The Indian Rupee
India imports more products from the United States than it exports to it. If we net the exports and the imports, we would need more USD to settle the international transactions. This is the reason why the demand for the US dollar is always high. This is also the reason why even trades with other countries happen in US dollars because most countries have a net demand of US Dollars and expect exports to bring more inflow of US dollars. The US Dollar has maintained supremacy over the other currencies in the past decades. Now, if suddenly the Indian markets import more heavily than usual, the demand will push the exchange rate further up. This is what happened after India’s import bill for oil increased after the recent increase in the global prices of oil. The imports have increased, the demand for US dollars in turn and therefore, the value of the rupee is depreciating. This has happened several times before, however, this time it appears to be a worse situation. The exchange rate has crossed its lifetime record high and has breached the 80-83 mark. This is after all desperate efforts from the Reserve Bank of India (RBI) including an increase in policy rates even though the same would result in higher inflation. RBI even took the unprecedented move of allowing exports in the rupee, however, the same did not gain much traction. Hence, the Government and Reserve Bank are being criticised for their failure to implement better policies to stop the depreciation of the rupee. However, there’s a flip side to this story that most people have not observed.
The US Dollar
The dollar Index is an index that measures the value of the dollar against a basket of 6 other global currencies – the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. In simple terms, think of the dollar index as an average of the exchange rates between the US Dollar and these currencies. The index depicts how the US Dollar is performing against other prominent currencies of the world. And the current trend is astonishing. The US Dollar Index has soared as much as 17% this year so far and is at its 20-year high. This means the US Dollar has appreciated heavily against the other six currencies. Why? Well, like the rest of the world, the United States too is experiencing inflation and expecting further price rises. Therefore, to control inflation the Federal Reserve of the United States has adopted a hawkish monetary policy stance which simply means, an increase in policy interest rates. If the interest rates are increased, the bank borrowings would be costlier and therefore, people would borrow less and in turn, also spend less. Similarly, people will also save more, instead of spending due to higher interest rates on deposits. Thus, the US Government expects to control inflation to some extent by increasing the policy rates.
Along the same lines, the corporates and institutional investors who have invested their money abroad in other countries markets, are now finding it more attractive to invest the money in their US markets since the interest rates have increased. So most investors are flocking to invest in US Government debt since it is one of the safest investment options in the world (as the US economy is stronger than others) and the same is now also offering a better return on investment. The 2-year US government bond which fetched 0.25% is now earning as high as 4%. Even though the United States is battling inflation and recession, it is still in a better situation than Europe. Besides, it’s been history that the United States economy bounces back the fastest after recessionary times. Hence, investors are pouring money into the United States. This also explains why Foreign Institutional Investors (FIIs) have downsized their portfolio in India. Similarly, the investors have withdrawn a lot of money from foreign markets and invested in the US markets. But this also means the US dollar has also moved from foreign country reserves to the US Federal Reserve and therefore, there is a short supply of the US dollars in the international market, which has, in turn, increased the foreign exchange rates. Thus, the increase in interest rate has strengthened the US Dollar and the exchange rates have shot up.
The United State Federal Reserve has been consistently increasing the policy rates this year with six consecutive rate hikes pushing the borrowing costs to a new high since 2008. The rates which stood at 0.25 to 0.50% at the beginning of the year, now stand at 3.75% to 4.00%. Thus, the exchange rates are bound to shoot up. While it is a dream run for the exporters in India who are earning more than usual, it is a nightmare for the Indian importers and even worse for the companies who have borrowed money from the United States, as they have to pay higher interest charges on the loan.
Is it the US Dollar or the Indian Rupee?
The US Federal Reserve is actively increasing interest rates in a bid to control inflation. However, the same has also resulted in increased foreign exchange rates. Though the decision is good for the United States, it is proving to be a nightmare for other countries. From India’s perspective, if you compare the Indian rupee against the other global currencies, the Indian currency hasn’t performed as badly, as it has performed against the United States. The Rupee is up against the British pound by over 12%, against the Euro by around 8% and against the Yen by 18%. So, when Finance Minister Nirmala Sitharaman said that it is not the rupee that is facing perilous capitulation, but the US dollar that has appreciated heavily, she is right. In fact, the RBI has done a fabulous job of maintaining the value of Indian currency amid such perilous times. The RBI even went on selling US Dollars, dipping into our forex reserves, in exchange for INR to increase its value. So, while the Government is doing everything that it can, it is the policy decisions of the United States that are affecting the policy rates. Think of it as a seller of a famous product restricting the sale of its product in the market – what will happen? The short supply of the product would obviously increase the price of the product. Here, the US Government is doing the same with its currency and therefore, it doesn’t seem like the exchange rate is going to decrease any time soon.