How are exchange rates determined?

July 6, 2013:
How does a typical rupee depreciation or appreciation occur? While it may seem a
complex process and in fact it is to some extent, but its not much different from how the
prices of your mangoes are determined?
While it may seem immature to compare currency movements with the prices of
mangoes, the most important factor determining their price is the same market forces
of demand and supply.
TWO-WAY RATE
The rupee/dollar rate is a two-way rate which means that the price of 1 dollar is quoted
in terms of how much rupees it takes to buy one dollar. The value of one currency
against another is based on the demand of the currency. If the demand for dollar
increases, the value of dollar would appreciate.
As the quotation for Rs/$ is a two way quote, an appreciation in the value of dollar
would automatically mean the depreciation in Indian rupee and vice-versa.
For example if rupee would depreciate, a dollar which once cost Rs 47 would cost say
Rs 59. So in essence the value of dollar has risen and the buying power of the rupee
has gone down.
Besides the primary powers of demand and supply, the rupee-dollar rates are
determined by other market forces as well:
Market sentiments: During turbulent markets, investors usually prefer to park their
money in safe havens such as US treasuries, Swiss Franc, gold in order to avoid losses
to their portfolios.
So this flight to safety would lead to foreign investors redeeming their investments from
India and would naturally increase the demand for dollar vis--vis the Indian rupees.
Remember the rupee/dollar rates during 2007 and 2008?
Even today we are seeing a lot of FIIs redeeming their investments from emerging
markets like India and are investing into US treasuries which are currently quoting at
higher yields. This has lead to Indian rupee depreciating to Rs 60/$.
Speculation: When the markets are moving vertically, theres a lot of speculation about
the expected changes into the currency rates due to the investments/redemptions of
foreign investors.
There are derivative instruments and over-the-counter currency instruments through
which one can speculate/hedge the underlying currency rates.
When speculators can sense improvements/deterioration of the sentiments of the
markets, they too want to benefit from such rising/falling dollar and they start
buying/selling dollar which would further increase the demand/supply of dollar.
RBI Intervention: When there is too much volatility in the rupee-dollar rates, the RBI
prevents rates going out of control to protect the domestic economy.
The RBI does this by buying dollars when the rupee appreciates too much and by
selling dollars when the rupee depreciates way too much. The same was recently felt on
June 12, 2013 when the rupee recovered sharply from Rs 58.95/$ level
Imports and Exports: Ever thought why our Government is trying to incentivise exports
and reduce imports?
There are a lot of schemes and incentives for exporters while importers are burdened
by many conditions and taxes.
This is to protect our economy from high rupee depreciation. Importing foreign goods
requires us to make payment in dollars thus strengthening the dollars demand and
exports do the reverse.
Major imports being fuel and gold; understandably even today we are a net-importing
country which means that we are importing more and exporting less.
Interest rates: The interest rates on Government bonds in emerging countries such as
India attract foreign capital to India.
If the rates are high enough to cover foreign market risk and if the foreign investor/fund
is comfortable with the Sovereigns fundamentals/credit ratings, money would start
pouring in India and thus would provide a fillip to rupee demand.
(The author is senior Vice-President, Bonanza Portfolio Ltd. The views are personal)