Exchange rate

Exchange rate

Subject: Economy

Section: External sector

Context:

On Monday, during intra-day trade, the Indian rupee hit an all-time low exchange rate of 77.6 against the US dollar.

Exchange rate:

Meaning?

The Rupees Exchange Rate vis-a-vis particular currency, say the US dollar, tells us how many rupees are required to buy a US dollar.

Changes in exchange rate implies?

If the rupee’s exchange rate “falls”-depreciates, it implies that buying American goods would become costlier. At the same time, Indian exporters may benefit because their goods now are cheaper to the American customers.

Determination of the ER:

• the exchange rate is decided by the supply and demand for rupees and dollars
• Imagine that in the beginning, one rupee was equal to one dollar. After a year, Indians demand more dollars in comparison to Americans demand the rupee. In such a case,the exchange rate will fall or weaken for rupee and rise or strengthen for dollar.

Determination of the ER in India:

• India follows a managed float i.e. the exchange rate is not fully determined by the market. From time to time, the RBI intervenes in the foreign exchange (forex) market to ensure that the rupee price does not fluctuate too much or that it doesn’t rise or fall too much all at once.

Example:

• One, crude oil prices go up sharply, the fallout would be that India would need more dollars to buy crude oil in the international market. That, in turn, would weaken the rupee because India’s demand for dollars would have gone up while the world’s demand for the rupee stayed the same.

This is where RBI comes in. To soften the rupee’s fall, the RBI would sell in the market some of the dollars it has in its forex reserves in return of purchasing rupee. This will soak up a lot of rupees from the market,thus moderating the demand-supply gap between rupee and dollars.

• Between April and December, the situation was the opposite. There was a $90 billion surplus on the capital account—meaning net $90 billion came into the country on such transactions—and a $26.6 billion deficit in the current account — meaning net-net $26.6 went out of the country on such trades.

Left unaddressed, the excess $63.5 billion would have led to a rise in the rupee’s exchange rate. To moderate, the RBI bought this excess amount of dollars (by paying rupees in the market) and added it to its forex reserves.

Is a falling the exchange rate necessarily a bad thing?

• Indeed, the exchange is often taken as a marker of the relative strength of an economy and relative size of forex denotes a country’s ability to pay its external debts.
• Most Developing Economies tend to run deficits on their trade and current accounts, which could lead to a rise in  India’s Exports—unless they import raw materials, which would become costlier.