Indian rupee ended 2021 at almost 20 months low and as the worst-performing currency in Asia (1). Yes, it is good for exporters as they earn more. However, it isn’t good for oil, imports, and people looking to travel abroad.
On 16th December, the Indian rupee fell past the 76 per USD mark for the first time since June 2020, with a record 76.25 valuation. In the past, it fell beyond 76 in March 2020 when the coronavirus cases had surged and economies came to a grinding halt.
As of writing this article, the Indian rupee is at 74.31, and reports suggest that it may remain weak for the rest of 2022 (2, 3). According to available data, we may see further depreciation of INR because of the widening trade deficit and foreign investors pulling out their funds from equities.
As of December 2021, the Indian trade gap increased to a record high of 22.9 billion USD due to increased imports. In addition, FPI, Foreign portfolio investments also dropped for the third consecutive month. It all contributed to the slid of the Indian rupee on the exchange market.
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The Fall of Indian Rupee
The above chart shows the Indian rupee’s USD exchange rate. The rupee breached the 76 to a dollar mark on 16th December 2021, an 18-month low. It had previously slipped past the mark on March 2020 amid the global restrictions to curb the COVID-19 spread, leading to an economic halt.
Dilating Trade Deficit
One of the major factors impacting the weakness of the Indian rupee last year was the record-high trade deficit in November. According to The Hindu report (4), the trade deficit had widened to as much as 22.9 billion USD because of higher imports and a slow rise in exports YOY. The below chart illustrates the Indian trade balance (in billion USD) between April 2019 and November 2021.
Higher Foreign Outflows
Another factor contributing to the rupee’s fall is a significant number of foreign investors withdrawing from Indian equities. As of 23rd December, foreign portfolio investors pulled out 17,677 crore INR from Indian stock markets.
Overall, the Indian rupee is under a lot of pressure. While the recent pullback in oil helped India, many analysts have forecasted higher crude prices in 2022. And since India imports over 80% of its oil, it could act as a headwind for the Indian rupee (5).
On the other hand, if the inflation and oil prices fall this year, our currency can swing back.
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Should You Be Worried?
Experts believe that there is no cause of concern over the declining rupee because if we look at the movement, it has been holding steady despite having a weak trade deficit number.
There has been a weakness in the fundamentals, which explains why the rupee should depreciate. Yet, experts believe that the depreciation has come from the dollar index moving higher, with the Fed showing positive intent of tapering and rate hikes.
Therefore, it aligns with the global fundaments, which is not a cause of concern.
“The RBI is looking to gain some clarity about the global flows and monetary policy, especially from the Fed. And once we have a better sense of the global picture, RBI can decide if it should intervene with the declining rupee or defend a particular level. However, the RBI is in a better position to decide on how and when to intervene,” said Suvodeep Rakhshit, Senior Economist at Kotak Institutional Equities, in an interview with Economic Times (6).
Rakshit further discussed the trilemma, three rates, currency rate, inflation, and interest rates in any country.
According to ET, any government or central bank tries and control two of those three rates, whether it is a combination of inflation and interest rates or a combination of interest and currency rates. And at present, it seems like the RBI is focusing on keeping interest rates low and inflation under control.
Rakshit acknowledges that the moment the growth comfort comes in, the worry about inflation rises. He discerns that RBI should start focusing on inflation as soon it sees some growth comfort (7).
“The exchange rate is a by-product because it moves with the dollar, capital flows, and crude prices. Also, many other exogenous factors affect the rupee, and it does not make sense to target the exchange rate. Yet, if the RBI targets inflation, it will have an impact on the exchange rate from a medium to long-term perspective anyways,” explained Rakshit.
In addition, the fall of the rupee is quite modest if we compare it to currencies of other emerging nations. The below chart indicates the year-to-date % change in currency value of select emerging countries as of 16th December 2021. Although the Indian rupee plunged 3.7%, it is modest compared to the currencies of other economies (8).
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But, How Do Currency Exchanges Work?
An exchange rate of a currency tells us its worth in a foreign country. We can also think of it as a price we pay to purchase that currency. For example, today, 1 USD is equal to 74.24 INR, and 1 USD is equal to 0.013 INR (9).
Types of Exchange Rates
There are two types of exchange rates:
As the words indicate, flexible exchange rates continuously change, whereas fixed exchange rates seldom change.
The Forex or foreign exchange market determines most currency exchange rates. These rates are called flexible exchange rates since they fluctuate on a moment-by-moment basis.
Major world currencies are flexible, including pesos, dollars, euros, yen, and pounds. Government and central banks don’t actively intervene or regulate exchange rates to keep their rate fixed. However, their policies can influence their rates long-term (10).
There are other currencies; the Saudi Arabian riyal, for instance, rarely change because their countries use fixed exchange rates. Rates of fixed currencies only change when their governments say so. These rates are pegged to the USD. They can control their currency’s worth since their central banks have enough money in their foreign currency reserves.
The central bank holds USD to keep the exchange rate fixed. For instance, if local currency value drops, the bank sells its reserved dollars for local currency. It reduces the supply in the marketplace, in turn boosting the value of its currency. It would also increase the supply of dollars, which sends its value down. In case the demand for its own currency rises, it does the opposite (11).
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Which Factors Affect Exchange Rates?
Many factors, including money supply, interest rates, and financial stabilities, affect currency exchange ranges. In short, what happens in a country influences the demand for a country’s currency.
The interest rate a country’s central bank pay is a big factor that affects the value of its currency. A higher interest rate means more value. Investors can exchange their currency for the higher-paying one and save it in a country that offers a higher interest rate.
Another major factor is the money supply created by the country’s central bank. For instance, if the RBI starts printing too much money, there will be too much of it chasing a few goods. In that case, currency holders will bid up the prices of products, creating inflation. And if the government starts printing too much money, it will lead to hyperinflation.
Often cash holders invest overseas where there is no inflation. However, they will find that there is not as much demand for their currency since there is so much of it. Hence, it will push down the value of the currency.
A currency’s economic growth and financial stability also impact its currency exchange rates. If the country has a strong and growing economy, investors will purchase its offerings. They will need more of their currency to do it, which increases its valuation. However, if the financial stability is not good, investors will be less willing to invest in that country (12).
The strength of a local currency is also influenced by the worldwide demand and supply of USD. Often, the influence of external factors outpowers internal factors. It is why the INR has been devaluing over the past decade.
As much as China wants to compete with the USD, it is still a global currency. Over 50% of all global transactions are done in the US dollar, and most economies worldwide also keep it as their reserves. That’s why USD is always in demand. As the USD becomes strong, it devalues other currencies, including INR, with time.
As we mentioned, crude oil imports are also major external factors that influence the price of INR. To pay for crude oil imports, we have to keep high USD reserves, meaning INR is constantly used to purchase USD in the forex market. Such high demand for USD in India puts negative valuation pressure on INR.
Other external factors like the global crisis, 2008 mortgage crisis, for instance, also influence the value of a currency.
The crisis started in the US, which led the US to print more USD to boost its GDP growth. Technically, its valuation should have dropped drastically. However, it got stronger post-2008 since it is the major portion of foreign exchange reserves of many countries worldwide.
It means if the value of USD drops, it can destroy the world economy. Therefore, countries start to hoard more USD during any crisis. It helps to protect the value of their reserves and also keep the valuation of USD stable.
Because if USD devalues, USD parked in other countries will also fall. China has the highest forex reserves with over 2,281,208 million USD, followed by Japan with 1,384,372 million USD, with India in the 4th position with over 603,007 million USD in its forex reserves (13). In other words, it is in the interest of major economies to keep the USD strong.
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Impact of Weaker Currency
It is not always bad to have a weaker currency, and most countries prefer to keep their currency weaker than the USD. There are several benefits of it;
Benefits of Weaker Currency
- Exports become profitable.
- Imports become expensive, leading to fewer imports.
- Hence, the domestic demand will increase, leading to higher economic activities and faster GDP growth.
- Higher export and lower imports improve a country’s current account deficit. It also leads to increased forex reserves of a country.
Drawbacks of Weaker Currency
- A surge in local demand and increased spending can lead to inflation.
- It leads to lower purchasing power; your iPhones will become expensive!
Benefits of Stronger Currency
- Cheaper imports
- Low inflation
- High purchasing power
- High currency demand
- Cheap debt
A strong currency can help governments raise cheap capital since a strong, stable currency sees more global investments with no desire for high-interest rates. People like to park their funds in a strong currency like the USD, and as the currency’s demand remains high, it will fetch higher returns with higher exchange rates. Even investors can profit by selling their holdings when the exchange rate goes up. In short, it is a win-win situation for all (14).
So why not every country aims for a stronger currency? Because of the immediate (negative) effect of their currency becoming strong, no government is ready to pay the price for the long-term benefits.
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Any country like India that imports more than it exports has more demand for the dollar, which is the primary reason behind INR being weaker than USD.
On the other hand, countries like the Bahamas, smaller and less industrialized, are not as dependent on imports as India. Hence, their CAD, current account deficit are not high, leading to a stronger currency.
Nonetheless, a currency’s strength is not a reflection of the economic health of a nation.
Besides the currency valuation, many other factors, including their GDP, work in tandem. For instance, while the currency of the Bahamas is stronger (1 Bahamian dollar = 1 USD), its GDP is at 12.42 billion USD (15), whereas India stands at almost 3 trillion USD.
So, should India focus on increasing its currency value? Let us know in the comments below!