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Knowledge Center » Economics » FACTORS THAT AFFECT THE EXCHANGE RATES

An exchange rate is the rate at which one currency can be exchanged for another currency, or simply the value of one currency in relation to the other currency .The exchange rate of most countries is determined by the market forces of demand and supply. The basic laws of demand and supply are applicable in the case of exchange rates as well, that is, demand is inversely and supply is directly proportional to price. In this article, we see factors that affect the exchange rate and how India fares in those parameters.

•    Current Account Balance
A current account shows the balance of trade of a country ie the difference in payments made and received. If there is a deficit, it means that the need for the foreign currency is higher than the amount the country realizes through exports and remittances. This excessive demand for the foreign currency in comparison to the domestic currency leads to the domestic currency depreciating. India’s current account deficit was as high as 5% of the GDP some time back but that has reduced after imports were contained and exports grew on the back of a depreciating INR.India ran a huge CAD because of huge imports of gold and crude, and unless a feasible long term solution can be worked out to reduce the demand for gold as well as oil, the currency will remain weak.

•    Inflation Rates
As a general rule, the exchange rate is inversely related to inflation that is higher the inflation in an economy, the weaker the currency and lower the inflation, stronger the currency. This is because purchasing power is also inversely related to inflation. If inflation in the country rises, the country’s exports will have fewer buyers abroad because of their higher price (which leads to lesser inflow of capital) while their imports will rise as consumers find imported goods cheaper ( leading to an outflow of currency) .In the longer term, this difference in outflow and inflow leads to a higher rate of exchange.  India’s CPI consistently roams around the 10% mark which is a huge cause of concern as it is among the highest in the world.This means that the INR has comparatively lesser purchasing power in comparison to other currencies.

•    Interest Rates
 By changing interest rates, central banks exert influence over both inflation and exchange rates, and varying interest rates affects the exchange rate and inflation. Higher interest rates give investors and lenders a bigger incentive to move their capital to the country. For example, if country X has a rate of 5% while country Y has a rate of 8%, all other factors excluded, an investor would prefer country Y. This inflow of capital from abroad strengthens the domestic currency.   When the Fed Reserve had announced last year that QE  tapering may start soon, the biggest reason for panic in emerging markets was that foreign investors would soon shift back to developed countries as interest rates started rising

•    Political Stability
Safety of capital is also very important and hence investors try to look for countries that are safe and have stable governments.  Political turmoil/safety issues can motivate investors to withdraw money from the country, an armed rebellion was one of the reasons that led to the Mexican peso crisis .Governance in India is a huge problem which has led to huge pile up of infrastructure projects waiting for approvals ,corruption and political instability ,slowdown in growth and high inflation .

•    Economic Performance
Economic Performance is always a huge factor dictating foreign inflow. Emerging economies are expected to grow at a higher rate than developed countries and that is why foreign investors seek to invest there .Higher the growth, more the investments made by foreigners, stronger the domestic currency because of the inflow. India’s economic performance has slowed down considerably since the ’08 crisis with the GDP growth rate falling by nearly 50%.While the global financial crisis and the lack of demand from all over the world is a huge reason, domestic factors like bad governance, high inflation and  the reluctance to pass economically benefiting legislatures cannot be ignored.