By : Aneesh Sharma

Factors that affect exchange rate

1) Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a
rising currency value, as its purchasing power increases relative to other
currencies. Those countries with higher inflation typically see depreciation in
their currency in relation to the currencies of their trading partners


2) Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation
and exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign
capital and cause the exchange rate to rise and vice versa

3) Current Account Deficits

The country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its
products. The excess demand for foreign currency lowers the country's exchange
rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests

4)Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can cause a
loss of confidence in a currency and a movement of capital to the currencies of
more stable countries.
Why is the INR depreciation bad?


The persistent decline in rupee is a cause of concern.


Depreciation leads to imports becoming costlier which is a worry for India as it meets
most of its oil demand via imports. Apart from oil, prices of other imported
commodities like metals, gold etc. will also rise pushing overall inflation higher. Even if
prices of global oil and commodities decline, the Indian consumers might not benefit as
depreciation will negate the impact.

The depreciating rupee will add further pressure on the overall domestic inflation and
since India is structurally an import intensive country, as reflected in the high and
persistent current account deficits month after month, the domestic costs will rise on
account of rupee depreciation.

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could get $2 for Rs 100, now you will have to pay Rs 30 more to get the same amount of
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savings to meet the funding gap between your education loan amount, and actual total
cost.




Exchange rate risk also drives away foreign investors which in
turn depreciates the local currency. Indian Rupee is currently
caught in this vicious cycle; it will have to find a stable level to
regain investors confidence.



The depreciating rupee has serious effects on the external debt
figures of the nation.
FACTORS THAT LED TO
DEPRECIATION OF INDIAN
RUPEE
1. Strong US Dollar



The main reason causing the rupee to fall is the immense strength of the Dollar
Index, which has touched its three-year high level of 84.30. The record setting
performance of US equities and the improvement in the labor market has made
Americans more optimistic about the outlook for the US economy, thereby
spurring greater hopes of QE tapering.

QE or Quantitative Easing refers to a complex stimulus process in which the
Federal Reserve pumps in about 80 Billion USD per month into the US
economy by purchasing assets such as bonds,stocks,etc.They have also kept
short term lending rates to near 0.This resulted in excess money in the US
economy which was then invested into emerging economies for better returns.
Since Mr. Bernanke made a statement about possible QE tapering, markets all
over the world reacted in shock as the excess money bought into emerging
markets would be taken back to the US economy as investors believe the US
economy is showing strong signs of recovery and targets are being met and
hence they would find it hard to fund CADs
The fact that the Euro zone is in a recession is just another reason why
investors are snapping up dollars. The monetary policies of the ECB and the
BoJ pose a threat to the value of the EUR and JPY whereas the next move by
the Fed should support the dollar. This divergence is bringing the dollar more
into the limelight as a 'safe haven'. Capital preservation is just as important as
capital appreciation in the present times and for this reason the direction of
the monetary policy and the consequent implications for the currency has
become very important.


The US dollar is looking like gold these days because the Federal Reserve is in
a very different position versus the ECB, BoJ and the RBA. The Federal
Reserve is talking about tapering asset purchases at a time when European
officials are considering more aggressive monetary easing measures such as
negative deposit rates.

2. Eurozone Crisis

The rupee is also feeling the pinch of the recession in the Euro zone. The euro,
which was seen holding the key level of 1.30, has dropped lower to 1.28 levels on
the back of deterioration in the local economic data. For the past month,
investors have been selling Euros and buying dollars on the premise that the
Euro zone is in a recession; and the ECB is considering more stimulus at a time
when the Fed is considering less. It is believed that Greece,Portugal and Spain
shall require more bailout packages .If the data shows a deeper contraction in
Europe and Mr. Draghi ( head of ECB) reminds investors that the Central bank
is watching the economic data carefully to see if additional action is necessary,
the EUR/USD could extend its losses.

Owing to the uncertainty prevailing in Europe and the slump in the
international markets, investors prefer to stay away from risky investments. The
credit rating agency's downgrade of India to BBB- with a negative outlook
the last of the investment grade has not helped its cause. Any outward flow
of currency or a decrease in investments will put a downward pressure on the
rupee exchange rate. This global uncertainty has adversely impacted the
domestic factors and could lead to a further depreciation of the rupee
3. Current Account Deficit
Current account deficit means that the amount received from abroad is less
than the amount sent abroad. It includes imports , exports as well remittances
etc.


A large part of the import bill is driven by other resources as well. The facts
show that fertilizer imports surged by 30% in the last two years and coal
imports have doubled. Also, India remained a huge importer of Gold before
these stringent measures were taken. We also import 70% of our crude oil from
abroad and hence need USD to trade. We are a huge importer and hence, with
increase in the deficit the effect on the currency is much higher : the problem
of CAD continues to persist.


The Indian economy needs to debug its structural reforms and the gap
between the imports and exports.


With the reduction in exports and an increase in imports, on one side the
current account deficit has increased while on the other, the fiscal deficit is
also expected to be above the comfort levels due to increased subsidy. A
slowdown in the global economy has adversely reduced the demand for
Indian goods. The Eurozone, which is a major trading partner for India, is
also suffering from a crisis which impacts our exports .The falling
commodity prices on the other hand have increased imports resulting in an
imbalance between payments and receipts. India needed about 80 Billion
USD last year to fund its CAD, and the dependence on this external money
makes so vulnerable.
4.High Inflation
India has experienced high inflation, above 8%, for almost two years. If
inflation becomes a prolonged one, it leads to overall worsening of economic
prospects and capital outflows and eventual depreciation of the currency.

The Real Effective Exchange Rate (REER) index (6 currencies- Euro, Yen,
Pound Sterling, US Dollar, Hong Kong Dollar and Renminbi) has fallen by
13.84% during the last one year while the nominal rate has depreciated by
24%. REER index measure includes the level of inflation differences across
nations; it reflects a country's competitiveness in international trade. Thus
the trend suggests that the country's competitiveness (measured by REER)
has not improved as much as the decline in nominal exchange rate points out
mainly because of increase in domestic costs.

Under normal circumstances inflation is tamed by increasing interest rates,
but since India already has high interest rates, it does not leave that option
open, as it may lead to further slowdown in growth.
5.Policy Paralysis
Key policy reforms like Direct Tax Code (DTC) and Goods and Service Tax
(GST) have been in the pipe line for years. A retrospective tax law (GAAR)
has already earned a lot of flak from the business community ( Vodafone
case)


Attempts are being made to control the subsidy bills but fiscal deficit
continues to hover around 5% of GDP. The government announced FDI in
retail but had to hold back amidst huge furor from both opposition and
allies. This has further made investors sentiment negative over the Indian
economy


Due to corruption and red tapeism, infrastructural projects worth several
lacks of Crores are still in the pipeline, waiting for approval. The
government also hesitates to take stringent economic actions as they do
not want to upset their vote banks in the pre election year.
6. War in Syria
The recent fall in the rupee has been largely attributed to the sell off in all
emerging market currencies, due to the concern that the US may resort to
military action in Syria, according to Reuters.

The Indonesian rupiah hit a fresh four-year low on corporate dollar demand.
The Malaysian ringgit touched its lowest in more than three years on selling by
foreigners, while the Thai baht hit a three-year low on capital outflows. The
Philippine peso fell to its weakest in more than two and a half years as local
stocks plunged.

If there is war, investors flock to safer havens, and there is no asset safer than
the US Dollar. Hence, demand for the US Dollar will increase and the buying
pressure will raise the price


7. Food Security Bill

Another reason for the rupees decline is the passage of Food Security Bill in the
Lok Sabha.

The cost of the implementation of the bill has been put at around Rs 1.3 lakh
crore annually.

There are fears that the bill may adversely impact the governments ability to rein
in the fiscal deficit at targeted 4.8 percent of GDP for this year. Finance Minister P
Chidambarams assertion the execution of the scheme will not breach the red line
on the deficit did little to calm the forex market. An increased deficit puts
pressure on the government
8. Speculation

A lot of fluctuations in the INR were because of the increased volatility
in the market which is caused by excessive speculation. Due to a
summation of the above stated reasons, hedge funds/traders believed
that the INR will further weaken. Hence they started selling INR in the
markets to capitalize on the downside later on. Due to an excess of
buying pressure on the USD/Selling pressure on the INR,the INR fell
down even further .
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