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The Indian Rupee (INR) seems fairly stable against the USD (1 USD = 62-64 INR) in the recent times even though most other currencies have weakened against USD, some by 20-30%. Apparently, INR is responsive to most other currencies these days except the USA. Is it related to the strength of the Indian economy, or that INR has already fallen to its lowest point well before other currencies?

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  • $\begingroup$ Check what the central banks are doing? $\endgroup$ – pyCthon Jul 24 '15 at 0:26
  • $\begingroup$ because there are more INR buyers than sellers $\endgroup$ – rupweb Jul 24 '15 at 20:02
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To answer this question, lets dive into some of the factors that generally determine foreign exchange rates. I've outlined the two of the most widely discussed factors below.

  • Current account balance

    An economy's current account is a component of an economy's balance of payments and is a measure of the economy's financial transactions with the rest of the world. The current account measures transactions such as those involving goods and services, but also wage income, financial transactions, dividend and interest payments and so on.

    The current account is therefore also a proxy for the structural supply and demand conditions for an economy's currency. An economy running a current account deficit sees net outflow of currency, while an economy running a surplus sees net inflow of currency. In these transactions, the party that is funds receivable will generally have to exchange the foreign currency received for their own currency, which means that they will have to sell their foreign currency holdings in the foreign exchange markets. For economies running a currency account deficit, this means that there is a structural supply of that economy's currency to the market, which all else equal results in a depreciating trend.

  • Interest and inflation differentials

    I've grouped interest and inflation differentials here since the correlation between an economy's rate of interest and its inflation rate are highly correlated. To understand why, I encourage you to read up on for instance Irving Fisher's Equation or Eugene Fama's paper on the matter.

    In short, an economy with high relative interest rates will all else equal attract more capital, since the prospect for capital gains are higher here, than the country to which it is compared. However, high interest rates are generally caused by loose monetary conditions, that is to say expansion of the monetary base or inflation (a decrease in purchasing power of one unit of currency).

    However, also understand that monetary expansion is necessary in well-functioning economies. Some schools of economics, for instance, advocate that the monetary base be expanded by the rate of long-run real GDP growth. Other scholars disagree with this idea, but this is merely to show that the nominal interest rate differential between two economies cannot stand alone.

    Taken together, economists have studied the effects of interest rate differentials on foreign exchange rates, under the umbrella term interest parities. Please read up on these yourself, but suffice it to say that these hypotheses of interest rates and foreign exchange rates roughly predict that, on the long term, interest income made from a deposit in a foreign currency funded by a loan in the home currency, will on average be outweighed by an depreciation in the foreign currency. In short, all cancels out, and you cannot make any significant profits from the foreign exchange carry trade.

In terms of the Indian Rupee specifically, it has generally been in a long-term depreciating trend against the US Dollar, as is the case with most other developing nations' currencies (BRL, ZAR, PLN, MXN etc.). I do not have any personal opinions as to the direction of the INR, but following is my two cents' worth on how to couple the above points to the INR specifically. India runs a current account deficit, however much smaller than that of the U.S. India, along with other developing economies, have seen a growing discrepancy between inflation rates and economic growth, meaning that while economic growth has slowly diminished, inflation rates have stayed relatively elevated (please look these figures up yourself to check my claim). Furthermore, monetary authorities might wish to intentionally depreciate the value of its currency, since a weaker currency means that the economy's competitive standing improves.

I hope the above helps shed some light onto some of the factors that determine foreign exchange rates in general. However, this is by no means an exhaustive list or explanation. If you wish to learn more about foreign exchange markets, I encourage you to read for instance Piet Sercu's "International Finance" or similar works.

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