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There are a wide range of possible factors that influence the value of a currency. These factors are often interlinked, and result in the appreciation or depreciation of a currency in Forex Market. Depreciation of a currency means that its value has reduced with respect to the US Dolar. Convesely, appreciation refers to the strengthening of the currency with respect to the US Dollar. The value of a currency has a far reachng impact on all the aspects of the economy. Following are some of the factors impacting the value of Indian Rupee:
Inflation
Higher inflation leads to depreciation in the value of currency and lower purchasing power. Lower purchasing power leads to a drop in demand which gradually results in lower economic activity.
A low inflation does not guarantee a favorable exchange rate as myriad other factors are also involved, but a high inflation rate is very likely to adversely impact the exchange rate.
High inflation also pushes the cost of raw materials up. For a business, this may lead to lower profit margins, lower demand for the goods, or both. Such an economic outlook does not provide a promising opportunity for the inflow of funds from investors, both domestic and foreign. On the contrary, it might result in foreign funds especially FPI flowing out of the economy leading to Rupee depreciation. Investors follow the leading economic indicators of a country and are wary of directing their funds to a country that does not manage its inflation well.
Similarly, the opposite is also true. If the value of Rupee depreciates, due to external factors, it may result in increasing the cost of imports. As the cost of raw materials rises, the cost of final products also moves upwards possibly leading to inflation if it happens on a large scale.
Interest Rates
Through its monetary policy, RBI is responsible for modifying the interest rates to control the supply of money in the economy.
When the interest rate is lowered, the high supply of Rupee leads to inflation. Inflation leads to depreciation in the value of Rupee. If the inflation in India is higher than inflation in the USA, the inflation differential leads to the value of the Rupee depreciating vis-a-vis USD. A weaker Rupee, high inflation, and lower interest rates do not offer a favorable outlook for investors resulting in a lower inflow of foreign investment.
High inflation also leads to an increase in the cost of raw materials for a business, leading to thin profit margins or driving up the prices of products making them less affordable. This further negatively impacts investor sentiments.
Conversely, higher interest rate leads to a better economic outlook, lower inflation, and more opportunities for foreign investors to enter the market.
Political and Economic stability
A politically and economically stable country attracts the flow of investment both from domestic sources and outside. A booming economy with high growth potential draws and creates opportunities for investors. Conversely, a country marred by political upheaval and bleak economic outlook would keep investors away.
Public Debt
Countries engage in large-scale deficit financing to pay for their public sector projects. For this, a country must maintain a healthy debt. A high debt burden may lead to erosion of forex reserves thus impacting a country’s ability to cushion its exchange rates.
Lower reserves and high public debt also increase the risk of default for the country, making investors wary of investing. It also can lead to FPIs flowing out of the country. Lower investment further aggravates the situation of a country in need of funds for its projects, both public and private.
Fundamental Fiscal and trade-related factors
Countries with high trade deficits have generally weak currencies. The currency depreciates further if the trade deficit grows. A high trade deficit means India is a net importer. To import, a country needs to buy dollars to pay for the imports, thus effecting a stronger dollar. India is historically a trade deficit country.
An important indicator determining the strength of a currency, especially the Indian Rupee, is the months of Forex reserves cover left. A high Foreign Exchange reserve allows RBI to intervene in the Foreign Exchange market to keep the Rupee in the desired range. When the Rupee depreciates and risks exiting the healthy range, RBI starts selling the forest reserves to check the downward trend. Thus, a higher Forex reserve enhances the ability to control the value of the Rupee.
A high fiscal deficit leads to excess money supply in an economy, which fuels inflation, and increases the probability of Rupee depreciation.
Government intervention
As already discussed, a country prefers to keep its exchange rate range-bound. If the Rupee depreciates below a level, RBI intervenes by selling the foreign exchange to lift the Rupee in the preferred range. Currency manipulation is another way a government intervenes in controlling the value of currency. It refers to artificially devaluing a currency to boost exports. China often resorts to currency manipulation to make its exports more competitive.
Capital Flow – FDI and FPI
Among FDI and FPI, a higher FDI proportion is better for an Economy compared to a higher FPI in the mix.
This is because FDI entails acquiring controlling interest, participation in day-to-day operations, and management of a company. It usually has a larger time horizon as it may take years from the conception of a project to its completion.
Conversely, FPI has a smaller time horizon and does not involve participation in day-to-day operations or management. During a crisis, due to higher volatility, it’s easier for FPI funds to move out of the economy compared to FDI. For this reason, FDI is also referred to as stable money, while FPI is termed hot money.
If FPI is significant in an economy, there is a risk of high volatility during an economic crisis. These funds can easily flow out of the economy, depreciating the local currency, and aggravating the situation further. FDI on the other hand is more stable, and less volatile during any economic crisis, as these funds are generally in for the long haul, more involved in the actual business instead of just profiting from market fluctuations like FPI, and have higher stakes in an enterprise.
Higher FPI, during tough economic times, might create a domino effect. High funds move out of the economy, markets fall, and currency depreciates. This increases the cost of imports and triggers inflation further adding to the economic woes.
Fed Monetary stance
The Fed, through the Fed Open Market Committee (FOMC), controls the Fed fund rate. The decision whether to increase or decrease the rate depends on the economy’s needs. Generally, Fed rates are increased to control inflation and decreased to spur economic activity.
When Fed rates are increased, the US Bond yields also rise. This results in the flow of funds in the economy, as investors, both domestic and outside, prefer to invest in risk-free bonds over risky equity assets. Movement of Funds due to attractive bond yields and higher interest returns, increases the flow of funds from outside into the US economy, thus strengthening USD vis-à-vis other currencies including Indian Rupee. A stronger dollar also means a higher Dollar Index, which is explained below.
Dollar Index
The dollar index reflects the strength of the dollar weighted against a basket of hard currencies. It factors in the exchange rate of six foreign currencies. The six currencies are – euro(EUR), Japanese yen(JPY), Canadian Dollar(CAD), British pound(GBP), Swedish Krona(SEK), and Swiss franc(CHF). This index acts as an indicator of dollar value in foreign markets. When the value of the Dollar index goes up, the Dollar strengthens and the value of Rupee depreciates, and vice versa. This creates a domino effect. A stronger USD also means that more money flows into the US economy including that from the Indian origin, which further depreciates the INR comparatively. This spills over to Trade also. When Rupee weakens vis-à-vis USD, imports become costlier thus making the imported raw materials costlier. This higher leads to an increase in the prices of goods triggering inflation which further depreciates the Rupee.
Conversely, a dip in the Dollar Index value results in the strengthening of other currencies including the Indian Rupee, flowing out of money from the US creating investment opportunities in other economies including India, relative reduction in imports, lower inflation in India, etc.