Indian Rupee standing against Dollar is not hidden from anybody – Crashing day by day. See the above chart. Presently Dollar value is hovering between Rupee 73 and Rupee 74. It was somewhere around Rupee 59 in May 2014. From there it has climbed to around 74 during the recent time (a jump of around 25%).
But why did it happened? Is it bad or good? In fact, some economists are of the view that fair value of Dollar against Rs is around Rupee 80.
Let’s understand the mystery behind the Rupee value in the following article.
Reasons for fall of Indian rupee
We will start with some academic definition and will try to see what is happening in the background from the economic point of view.
By definition, we know that the exchange rate is the amount of Rupee which needs to be spent to buy a foreign currency like US dollar (US$).
If we say the exchange rate is 59 Rs/US$, it means to buy one US$ you have to spend Rs 59. While when you say the exchange rate is 74 Rs/US$, it means to buy one US$ you have to spend Rs 74. So now you have to shell out more Rs to get the same amount of US$. It means the value of US$ increase while of Rs is decreased. This scenario is called Rupee got depreciated.
Principle 1: If exchange rate increases, Rupee value is said to be depreciated i.e. the value of Rupee falls. If exchange rates decrease Rupee is said to be appreciated i.e. the value of Rupee is increases.
Above fact exist only the way we defined the exchange Rate, which is Rs/US not the other way round
Why Exchange rate changes
Let’s understand it by taking a simple example (Technically not right but good for clearing the concept). Let’s say there is is a country which is having which produce only apples. It can produce a number of apples as it wants. Now somehow it also gets some mangoes from some other country.
Case 1 = Country has produced 100 Apples and having 10 Mangoes
Case 2 = Country has produced 100 Apples and having 20 Mangoes
Also, consider that transaction can happen only in term of Apple and Mangos only. If a person in the country is having Mangoes and want to have Apple he can get them in return mangoes with Apples and vice versa.
Think for a movement in which case price of Mangoes would be more in term of Apple. Off-course in case 1 as there are 10 mangoes against 100 Apple ( 10 apples for each mango), while in case 2 there are 20 Mangoes against 100 Apples. ( 5 apples for each mango). Another way of saying is that the value of Apple will be more in case 2 as now only 5 apples are required to get 1 Mango rather than 10 apples.
Now replace Apples with Rs and Mangoes with $. In case 1, the value of Rupee would be less when there are less number of US$, the contrast to case 2 when there are more $ (Mangoes)
Principle 2: Value of Domestic Currency will fall (Domestic Currency Depreciation or Exchange Rate increases) if there is less supply of Foreign Currency or more demand for foreign currency or vice-versa.
A better way to explain Principle 2 is as under:
Let’s say, India in total is having Dollar reserve of value $1 Million. Let’s say some foreigner comes to India for tourism. He needs to spend in Indian Rupee so he will get his US$ converted into Rupee. This will result in more supply of US$ and hence its price will fall.
In another case, let’s say some Indian want to buy imported Car or want to go for a holiday in the USA. In both the case he requires US$, he cannot pay in Indian Rupee. That person requires Dollar so demand for Dollar will increase. When it will happen than Dollar price will be more.
What is causing Rupee depreciation
Now any event which affects the supply or demand of foreign currency will be going to affect the value of Rupee.
1. Increase in Price of Crude Oil: => More Demand for US$
India meets its most of crude oil requirement through import. Whenever we import we need to pay the money but in which currency? Off-course in most international acceptable currency which is US$. So increase in price crude will going to cause more outflow of US$. That is more demand for US$. So the Rupee depreciation.
2. Increase in US Fed Rate => Less supply of US$
This is the proxy of interest rate in the USA. To understand its effect let’s take a case ( only taking the interesting effect, ignoring the other cost involved)
Case 1 : Interest rate in INDIA = 7% and interest rate in USA = 5%
Case 2 : Interest rate in India = 7% and interest rate in USA = 8%.
Now if you are a USA citizen and having 1 Million US$. You have to take a decision where to invest. You, as a rational investor, will choose to invest in India in Case 1 and USA in Case 2 provided investment cost and risk in both of the country is same.
But investment cost and Risk varies from country to country. For instance investment, USA is not so high as in India. So to attract the Dollar, the interest rate should not be just higher but much higher than in the USA.
Higher the difference between USA Fed rate and India Rate more attractive the Dollar to Indian. Recently Fed increases its interest rate which has reduced the interest differential between interest rate in USA and India so less Dollar supply.
3. Trade War => less supply of US$
Trump administration is having a protective view toward international trade. So it has taken various measure to protect its market. Like the increase in import duty etc. Other countries retaliate with an increase in import duty for US products. All this has led to de-globalization or sentiment towards it. Also, there is very much uncertainty in USA administration and this lead to an uncertain environment for foreign investment. All of this led to the discouragement of international transaction/investment. In fact, FII in India has decreased for the last year.
In this article, we have seen major reasons behind the fall of the Indian rupee. In our next article, we will see the possible steps that RBI can take to stop this depreciation and boost the exchange rate.
Please feel free to share your views on this article.