Foreign Exchange Rate in India

This article provides an essay on foreign exchange rate in India.

Introduction:

Related to the problem of balance of payments is the macro issue of foreign exchange rate.

The balance of payments is influenced by the foreign exchange rate. Exchange rate is the value of national currency in terms of a foreign currency. Thus, currently (September 20,2013) one US dollar is exchanged for around Rs. 62.

Thus Rs. 62 to a dollar is the foreign exchange rate of rupee in terms of US dollars. Changes in foreign exchange rate affect the prices of exports and imports which in turn determine their volume and thereby determine balance of payments of a country. Since exchange rate is a price, its determination can be explained through demand for and supply of foreign exchange.

However, in the long run the foreign exchange rate between the two currencies is determined by the purchasing powers of the two currencies in the domestic economies. In the short run, the demand for imports and exports of goods and services (that is, both visible and invisible items), magnitude of capital flows between the countries affects demand for and supply of foreign exchange and thereby determine the exchange rate between the currencies.

The system of exchange rate in which the value of a currency is allowed to adjust freely or to float as determined by demand for and supply of foreign exchange is called a flexible exchange rate system. The flexible exchange rate system is also called floating exchange system. At present, in most of the countries of the world (including India), the flexible exchange rate system prevails.

On the other hand, if foreign exchange rate, instead of being determined by demand for and supply of foreign exchange, is fixed by the government, it is called the fixed exchange rate system which prevailed in the world under an agreement reached at Bretton Woods in New Hampshire in July 1944. Therefore, fixed exchange rate is also often called Bretton Woods System.

Under the Bretton Woods fixed exchange rate system, exchange rate is not determined by demand for and supply of foreign exchange but is pegged at a certain rate. At the fixed exchange rate, if there is disequilibrium in the balance of payments giving rise to either excess demand or excess supply of foreign exchange, the Central Bank of the country has to buy or sell the required quantifies of foreign exchange to eliminate the excess demand or supply. But in the mid seventies Bretton Woods system of fixed exchange rate system in which US dollar played a key role collapsed as the USA could not keep constant the price of US dollar in terms of gold.

In a fixed exchange rate system the government has to buy or sell foreign exchange in order to maintain the rate at the controlled level. However, under the fixed exchange rate system, the value of one’s currency can be changed occasionally. For instance, in June 1966, the value of rupee in terms of US dollar and U.K’s pound sterling was lowered.

Again in July 1991 India reduced its value of rupee in terms of US dollar by about 20 per cent. Such a one-time lowering of value of its currency in terms of foreign exchange occasionally by a country is called devaluation as distinguished from depreciation which under flexible exchange rate system can often take place under the influence of changes in demand for and supply of a currency.

On the other hand, with a fixed rate exchange system if a country raises the value of its currency in terms of foreign currency, it is called revaluation. It should be noted that since March 1993 India has adopted flexible exchange rate system and has also now made its rupee convertible into a foreign currency.

In fact, at present the Indian rupee can appreciate or depreciate every day depending on the demand for and supply of US dollar and other foreign currencies and demand for and supply of the Indian rupee.

Foreign Exchange Rate, Balance of Payments and Capital Inflows and Outflows:

Changes in foreign exchange rate have an important effect on the balance of payments of a country. When there is depreciation or devaluation in the currency of a country, its exports become cheaper and imports costlier than before.

This causes exports to increase and imports to decrease causing reduction in deficit in balance of payments. Thus in order to check increase in deficit in balance of payment and to restore equilibrium in it, devaluation or depreciation of the domestic currency against foreign currencies is often undertaken.

Besides, the foreign exchange inflows in various forms such as those resulting from rising exports, portfolio investment by FIIs (Foreign Institutional Investors), foreign direct investment (FDI) not only causes appreciation of exchange rate of the domestic currency but also leads to the increase in money supply in the economy and therefore inflationary situation in the country.

Thus higher appreciation in the value of rupee against US dollar in 2007-08 in India was the direct result of large capital inflows in India. The price of Indian rupee against US dollar rose from around Rs. 45 in January 2007 to 39.5 in Sept. 2007, that is, over 11 per cent appreciation in the year 2007 alone.

This appreciation of rupee was driven by foreign exchange inflows partly by rising software exports but more importantly inflows by FIIs coming in large quantity to take advantage of the stock market boom in India. Besides, foreign exchange inflows through NRI deposits lured by higher interest rates in India than those prevailing in their country of residence took place. Further, large capital inflows through foreign direct investment (FDI) in India also increased in 2006-07 and 2007-08.

These large inflows of foreign exchange in India through its effect on the supply of dollars in foreign exchange market would have caused a very high appreciation of rupee vis-a-vis US dollar but RBI did buy some dollars from market from time to time to prevent it and built up reserves of foreign exchange. But RBI could not buy dollars as fast as the large inflows came in. This resulted in appreciation of rupee in 2007-08. RBI could not ensure foreign exchange rate stability in situation of large capital inflows by buying sufficient amount of dollars from the market.

Again in Sept. 2011 there had been large capital outflows from the Indian economy resulting in increase in demand for US dollars and therefore depreciation of Indian rupee. The value of Indian rupee which was Rs. 43 to a US dollar in July 2011 declined to around Rs. 53 to a US dollar in the second week of December 2011. To prevent excessive depreciation of the Indian rupee RBI intervened and sold US dollars from its foreign exchange reserves.

Further from May 2013 FIIs started withdrawing capital from debt market and capital markets as a result of which demand for US dollars rose for sending it for investment in the US. This was triggered by the statement of the governor Ben Bernanke of the US Federal Reserve that as the US economy had revived; it would start unwinding the quantitative easing (QE) which was adopted to give stimulus to the US economy.

This led to capital outflows from the emerging economies including India to the US. Besides, India’s large current account deficit which was estimated at a very high level of 4.8 per cent of GDP in 2012-13 was caused by rapid growth of imports, especially of gold and crude oil on the one hand and stagnant exports on the other also lead to the net increase in demand for US dollars. In the months of May and June 2013 about 9 billion US dollars were withdrawn from India and contributed to capital outflows from India.

Thus large capital outflows by FIIs and large current account deficit (CAD) led to the sharp depreciation of the value of Indian rupee which was around Rs. 56 to a US dollar in the first week of June 2013 fell to 61.21 to a US dollar on July 8, 2013 and further hit a record low level Rs. 68.83 to a US dollar on August 28, 2013. This prompted Reserve Bank of India to take steps to squeeze liquidity in the Indian banking system whose funds were being used for speculative activities in the foreign exchange market.

Though depreciation of a currency is considered to be desirable as it boosts exports and reduces imports. But a sharp depreciation of rupee in the present macro-economic situation has a serious consequence. Not only will it make imports costlier and fuel another round of inflation, it will also restrain the RBI from pushing through the cuts in repo rate and cash reserve ratio urgently needed for kick-starting investments and boosting growth Breaking out of this policy logjam requires that the government should curtail current account deficit (CAD) by taking steps to boost exports by increasing its competitiveness and undertaking its diversification and also cut imports by imposing high tariffs on luxury imports, as it has already raised imports duty on gold from 6% to 10%. Besides, it should make reforms in foreign direct investment policy so that stable capital inflows are attracted to the Indian economy.

It follows from above that portfolio capital flows result in a lot of instability in foreign exchange rate of rupee which adversely affects our real economy through its effects on our exports and imports. Dr. Manmohan Singh who is considered as votary of globalisation in its address to the United Nations General Assembly in Sept. 2011 called the attention of world leaders to its risks. He said, “Today we are being called upon to cope with negative dimension of globalisation and global inter-dependence”.

He further said that US, Europe and Japan faced with economic slowdown are affecting confidence in world financial and capital markets creating a lot of economic instability which has a negative impact on emerging economies like India. He added that world had taken for granted the benefits of globalisation and it is time that UN asks its development agencies (World Bank, IMF) to ensure inclusive and sustainable development for vast sections of humanity.

He rightly warned against protectionist measures as a response to the global economic crisis, which he said has “deepened even further since 2008, in many respects.” Calling for better coordination of macroeconomic policies of major economies, Singh said: “We should not allow the global economic slowdown to become a trigger for building walls around ourselves through protectionism or erecting barriers to movement of people, services and capital.”

Another conclusion which follows from above is that there is a clash between foreign exchange rate stability and domestic price stability and RBI has been attempting to strike a balance between foreign exchange rate stability and domestic price stability. If in order to ensure foreign exchange rate stability RBI mops up sufficient dollars, it will result in pumping large sum of Indian rupees into the economy which will lead to the large increase in money supply causing a high rate of inflation.

If to check inflation and ensure price stability, it does not mop up dollars from the market and let dollar inflows, this will result in appreciation of rupee. Thus it has to strike a balance in buying dollars from the market so as to check inflation one the hand and to prevent too much appreciation of rupee. It is important to note that appreciation of rupee adversely affects India’s exports and leads to loss of jobs.

Appreciation of rupee also makes imports cheaper causing increase in them. Fall in exports and rise in imports adversely affects balance of payments on current account. However, more imports brought in through appreciation of rupee adds to aggregate supply of output and help in controlling inflation. On the other hand, too much depreciation of rupee is also bad because it makes imports costlier, especially of fuel oil. Higher value of imports also adversely affects balance payments.