From UPSC perspective, the following things are important :
Prelims level : Factors affecting currency's value
Mains level : Paper 3- Factors affecting rupee's value
The article explains the factors affecting the Indian rupee’s value against the dollar in implications of change in value for the Indian economy.
Factor’s affecting rupee’s value
- First, India’s foreign exchange reserves need to be considered, which have been increasing quite rapidly.
- Second, there are daily fluctuations caused by foreign portfolio investment (FPI) flows.
- Third, there is the external factor of the dollar, when the US currency strengthens against the euro, the rupee tends to decline and vice-versa.
- Fourth, there is the concept of the real effective exchange rate (REER), a construct of economists in which relative inflation comes into play.
- If inflation in India is higher than in countries associated with its export basket of currencies, then the rupee is overvalued and will correct through depreciation.
- Fifth, at what stage will the RBI intervene by buying or selling dollars to stabilize the Indian currency also matters.
Let’s look at some of these factors in detail.
Impact of the U.S. economy and Fed
- The dollar is driven by the US economy as well as its Federal Reserve’s policies.
- The Fed’s recent indication that it would raise its policy rate of funds in the years ahead was enough to strengthen the dollar and weaken the rupee. As an increase in US rates could see global investor money flocking back to the US, the dollar gained in relative value.
- The dollar should logically be strengthening, given improving US growth, now reinforced by the Fed.
- The inflation factor, however, has been curious.
- Indian inflation will be high in India and hence also the rupee’s REER.
- To the extent the market understands this concept and uses it for valuation, it should be pushing the rupee downwards.
- But the pressure will be less this time as global inflation is also being raised by rising commodity prices.
- Indian inflation may not be so much higher as to warrant a deep depreciation.
Increase in Forex reserves
- An increase in forex reserves is an indication that India is getting in more dollars than we are spending.
- This also means that our combined current and capital accounts are in surplus zone.
- However, India’s current account will go into a deficit this year, as imports will be greater than exports, but will not be very high. Maybe 0.5-1% of GDP.
- The capital account can get tricky.
- Inward foreign direct investment was high in 2020-21.
- At $60 billion in equity and $80 billion overall, it was one of the world’s highest.
- Therefore, capital flows should remain strong.
- External commercial borrowings could slow down amid weak investment within India.
- So the fundamentals suggest that the rupee should be stable, with a tilt towards depreciation.
The RBI intervention
- The RBI’s surplus liquidity and accommodative stance have not worked in favour of the rupee.
- In response to its April policy, when RBI affirmed its dovish stance, the rupee began falling on expectations that if RBI kept rates low at a time of high inflation and excessive market borrowing by the government, investors will potentially move out.
- This pushed the rupee towards the 75 level against the dollar, but reverted with time as RBI kept infusing liquidity and managed the yield curve.
- In April, RBI bought $4.2 billion worth of the US currency.
- Exports have grown smartly in the first two months of 2021-22, and at this stage, the central bank would not want to that trend by stalling the rupee’s depreciation.
Taking all these factors into account, one can foresee the rupee moving in the range of ₹74-75 to the dollar, unless there’s a shock of some sort, though none looks likely at present.