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The replacement rate of the currency of a country in relation to the currency of other country depends on the comparative trade advantages and economic strengths of the countries. If one Us dollar is equal to 45 rupees, it plainly means that in the Us, if a dollar fetches 45 oranges while in India, a rupee would fetch only one orange of equivalent size and quality.
Just like any other commodity, the currency of any cheaper is based on dynamics of provide and demand, and its value depends on trading in currency exchanges all over the world. Higher the examine for a currency on an exchange, the stronger it becomes and vice versa. However, for currencies like Inr which are not traded on exchanges, the value depends on capital inflows in the country.
Appreciation & Depreciation of currency:
A currency appreciates means its value has increased in relation to other currency. A currency depreciates means its value has decreased in relation to other currency. Eg. If 1 $ costs Rs 45 and if it now costs Rs 44, this means rupee has appreciated in its value (i.e. Instead of Rs 45 you will get 1 $ in Rs 44, this also means the dollar has weakened). Similarly, if 1 $ costs Rs 45 and if it now costs Rs 46, this means rupee has depreciated in its value (i.e. Instead of Rs 45 you will get 1 $ in Rs 46, this also means the dollar has strengthened).
Why do currency values fluctuate?
There are many participants in any foreign replacement market. These entities -- like banks, corporations, brokers, even individuals -- buy and sell currencies everyday.
Here too the universal economic law of examine and provide is applicable: when there are more buyers for a currency than sellers, its replacement rate rises. Similarly, when there are more sellers of a particular currency than buyers, its replacement rate will fall. This does not mean citizen no longer want money; it only means that citizen prefer to keep their wealth in some other form or other currency.
Scenario before occurrence of the current financial crises:
We were witnessing a surge of dollar-inflows into India due reasons like strong economic fundamentals and favourable company atmosphere, etc. These dollar inflows can be in the form of Foreign Direct Investment, folder inflows (foreign investment in equity), External commercial Borrowings by Indian companies abroad,
remittances to India by Non-Resident Indians. Since the Indian cheaper and the Indian stock markets have been on a roll, the capital inflows to India has been pretty strong which has primarily led to the appreciation in value of rupee. This huge influx caused a vital examine - provide gap between the dollar and the rupee. Going by the laws of examine & supply, the rate of the rupee vis-à-vis the dollar, rises.
Due to this exporters were settled at a disadvantage with a rising rupee, since the dollar became weaker. Thus a dollar which fetched Rs. 48 about two years ago today fetched only Rs. 44 eating into the behalf margins of exporters (since they earned less on their exports).
At the same time, importers benefit (since they need to pay less for their imports), but our cheaper was at a stage where we first needed to build our dollar reserves to meet our import payments and so the exporters' woes were needed to be tackled first.
The withhold Bank of India (Rbi), as the central bank of India, which oversees the foreign replacement (forex) supervision of this country quite often intervened to ensure that the rupee was adequately propped at a particular rate. This was done to ensure that there are no sudden currency shocks, to safe exporters and importers and above all, to ensure the feeling of 'national pride,' which is attached to a carport and salutary currency.
When the Rbi intervened to keep the rupee at some weak value, it had to buy the dollar inflows from exporters, from Nris, from foreign direct investors, from companies that borrow abroad. In any case the sellers of dollars need rupees to escort their businesses here. The Rbi buys or sells dollars via state-run banks to prevent inordinate volatility in the forex store and avoid any sharp appreciation or depreciation in the currency. When the Rbi purchases foreign currency inflows, the domestic monetary base or money provide or both rises since for every dollar the Rbi buys from the market, an equivalent whole of rupees gets injected into the system, adding to excess money in the law or the liquidity overhang. When the Rbi buys dollars, it pays for them using freshly printed rupee notes. This leads to greater money supply, higher prestige increase and inflation.
And precisely, here comes the catche. As Rbi sells more rupees, the money provide increases which means too much money chasing same (or less) whole of goods, thereby foremost to inflation. So in result one act of Rbi creates other problem. In other words, when the Rbi buys dollars from the Indian market, it simultaneously pumps rupees into the currency markets, creating the risk of inflationary pressures. The Rbi typically controls the appreciation by manipulating demand-supply dynamics of currency market. It purchases dollars (to create more examine for dollar) and sells rupees (to increase provide of Inr, thereby decreasing its value).
To include inflationary pressures, the Rbi adopts a portion termed as 'sterile intervention.' Under this measure, the Rbi sells Government of India bonds in the market. With the sale of these bonds, the rupee, which had flowed into the store for buying dollars, is once again sucked out of the market. When the Rbi buys dollar-denominated assets, (to create examine for dollars and sell out provide of rupee) it sells rupee-denominated securities to suck the rupees back. But when the Rbi has to suck out a whole lot of rupees back, it has to raise rupee interest rates, the Repo rate (the interest rate at which commercial banks borrow for short term from Rbi) and the Cash withhold Ratio (Crr).
This is how the Rbi protects the dollar-rupee replacement rates and yet, manages to include inflation.
Scenario after occurrence of the financial crises:
The sub-prime crises, bankruptcy, sale, restructuring and merger of some of the world's largest financial institutions caused cataclysmic disruptions in the international stocks and money markets. Imprudent financial decisions, fed by greed and bad luck, have seen global financial markets collapse.
The current financial crises that shook the global financial markets has seen unprecedented bailouts and infusion of dollars into the Us cheaper at a cost of many an emerging market, from where funds have been pulled out to flow back into America.
India, which was till recently having huge capital dollar inflows, now is experiencing flow of dollars outside the country due to selling of more Indian shares than bought (to the tune of over billion), thereby manufacture dollars scarce in India and reduced examine for rupees, simultaneously, as there is increased examine for dollars due to spurt in crude oil prices and the dipped capital inflows.
The dollar prices fell by some vital whole with respect to most of the currencies. Here in India the rupee rose to around 40-41 a dollar from around the 45 rupees a dollar. There is a lot of panic among the exporters because a weak dollar adversely affects the exporters, especially in the services sector who have all their expenditure in rupees and earnings in dollar.
The growing Indian trade deficit and the large fiscal deficit are also contributing to the fall of the rupee. The higher price of imported goods, especially oil (India is a heavy importer of oil), has also led to an increase in domestic inflation and a fall in the value of the Indian currency. High inflation and a strong increase in the Indian cheaper have already forced the Rbi to raise interest rates.
Example: think a firm; say 'K software' that has a behalf margin of 5 %. Now 'K software' bags a covenant of 100,000 Usd from a big Us based firm when the dollar Rupee replacement rate is 45 Rs a dollar. So the behalf of 'K software' would be 5 % of 100,000 i.e. Usd 5k (= 225k Rs at the replacement rate of 45Re= 1Usd) and expenditure which is in Rupees as Usd 95k i.e. 4275k Rupees. Therefore, 'K software' goes ahead with its scheme and when the scheme is completed the dollar gets weak and trades at 40 Rupees a dollar. Now 'K software' has already spent 4275k and now despite getting the promised 100,000 Usd they get only 4000K rupees and end up, in effect, paying 275k for developing the software. So weakening of dollar is detrimental for the exporters.
To elucidate it with other example; Say that replacement rate is Us 1 $ = 50 Inr. If an exporter X earns Us $ 1000 by exporting his goods/services to Us, his earnings in Rupee terms is Rs. 50,000. If the Rupee appreciates to Us 1 $ = 40 Inr, then in rupee terms the earnings of exporter will be Rs. 40,000. A fall in earnings despite the exports being constant. But the exporter who is based in India has to spend in Inr in India; he has less money at his disposal constraining his added increase by way of limiting his investment capacity.
Importers on the other hand have to pay less to import the same thing suppose you buy a 100$ iPod now you will have to shell out just around 4k instead of the earlier 4.5k. This is one of the reasons why all those Oil economies which are primarily the importers mouth very high replacement rates by regulating their currencies.
Reverse of what was happening before the crises:
Therefore, where the Rbi was sucking out the excess liquidity from the law caused due to huge capital dollar inflows, it is now compelled to reverse its stance and infuse liquidity back into the system. Where previously the Crr was hiked, Rbi now reduced the Crr, repo rate and adopted to increase the reverse repo rate(the interest rate at which Rbi borrows for short term from the commercial banks), since there is shortage of money provide in the law and therefore reduced prestige in the market.
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