The exchange rate is a topic like Cricket, where everyone knows everything and everyone know nothing. The recent fall in rupee exchange rate has confused many of us. As the economy is showing a sign of growth and the current government seems to be promising it becomes difficult to accept that rupee is weakening. This is something which is not understandable by many of us and creating the confusion. Let’s try to understand how the exchange rate mechanism works. The exchange rate is one of the most complex topics in economics and I know this is my audacity to try to simplify it.
Anyways, let’s see how it goes. Though the world has moved towards the floating exchange rates but let me explain the theory behind it. First of all, what is exchange rate? An exchange rate is the value of one currency in terms of other currency. In other words how many units of other currencies can be bought by one unit of a select currency. There are two ways by which the exchange rates get determined. Initially, all the currencies used to get pegged to gold and then the world shifted to United States Dollar (USD). Till the 1970s most of the currencies in the world were following the fixed exchange rate system, which means the value of one currency is fixed in terms of the value of other currencies. With the growing global trade and its complexities, the world could not sustain the fixed exchange rate system because it wasn’t a market-driven system. After that most of currencies shifted to floating exchange rate system which is a market-driven system. Now, what do you mean by market-driven system? The market-driven system means the exchange rate will get determined by the demand for and supply of a particular currency.
What determines the demand for and supply of a particular currency? There are various factors which determine the demand for and supply of a particular currency like exports and imports of goods and services, the flow of foreign investments, the flow of income from foreign country to domestic country and vice versa.
The Indian way
In India, we follow something called managed flexibility where Reserve Bank of India (RBI) decides a bracket (upper limit and lower limit) in which they allow the currency to float. If the exchange rate goes beyond the bracket then RBI intervenes into it. Let’s say if the rupee is weakening beyond the acceptable limit of RBI then RBI will try to sell some amount of foreign currencies from its reserves in the forex market to pull the rupee up. In short RBI itself will create a demand for rupee in the forex market so the value of rupee will strengthen. RBI will take exactly the opposite action if the rupee is strengthening beyond the acceptable limit.
What does it indicate?
Economists say that there is a general misconception that stronger exchange rate reflects the strength of a country and a weaker exchange rate reflects the weakness of a country. If we go ahead with the technical understanding then a stronger exchange rate is good for import dominated countries and a weaker exchange rate is beneficial for export-oriented countries since their goods and services will get a cost advantage in the global market.
Given the current complexities of the global financial markets, it is not easy to use fundamental knowledge to understand the exchange rate fluctuations. We all need to understand that the current exchange rate fluctuations are more of a speculative nature rather than fundamental reflections. In simple terms, current exchange rates are driven by the investors who trade in the financial markets to earn returns on their investments. Though the basic fundamental knowledge is very important to understand the exchange rate mechanism but it will be foolish to completely rely on it.
The current fall in Indian rupee is a result of local and global factors. There are many articles in newspapers which are trying to explain the current fall of rupee so I will not try to explain it in detail. There are local reasons like taxation issues and monetary easing (falling interest rates in India) as well as global factors like promising United States market which are leading to the outflow of foreign capital from India. This outflow of foreign capital is resulting into the weakening of the Indian rupee.
I personally disagree with the general economists’ view that the exchange rate doesn’t reflect the strength and weakness of a country. I accept that if India has to grow as an export-oriented country then weaker exchange rate will be helpful. Exchange rate gets determined by the demand for your currency and the demand for your currency shows your global strength. Not immediately but gradually India will have to go for stronger exchange rate if she wants to play the role of global leader.