Significance and Methodology of Exchange Rate System
- The Indian rupee hit an all-time low exchange rate of 77.6 against the US dollar.
- The previous lowest was 76.9, It has been a sharp fall in a matter of days.
About Exchange Rate System
The rupee’s exchange rate vis-a-vis a particular currency, say the US dollar, tells us how many rupees are required to buy a US dollar.
- To buy (import) a US product or service, Indians need to first buy the dollars and then use those dollars to buy the product.
- The same holds true for Americans buying something from India.
- If the rupee’s exchange rate falls: buying American goods would become costlier.
- But Indian exports may benefit because goods now are more attractive (read cheaper) to the American customers.
Exchange Rate Determination
- Free-market economy: exchange rate is decided by the supply and demand for rupees and dollars.
- In India, the exchange rate is not fully determined by the market.
- From time to time, RBI intervenes in the foreign exchange (forex) market to ensure the rupee “price” does not fluctuate too much.
Rupee’s demand and supply with other currencies
The BoP is essentially the overall ledger of how much rupee was demanded by the rest of the world and how much foreign currency was demanded by Indians.
- The BoP is divided into two “accounts” - Current and Capital.
- Current account refers to all transactions that are related to current consumption.
- Capital account refers to transactions for investment purposes.
- Indians ( or Indian entities such as companies and governments) and foreign nationals (or entities) transact in several different ways -
- All such transactions generate demand for rupees (among foreigners) and forex (among Indians).
- All transactions involving export or import of goods (cars, gadgets etc) are logged under the “trade account” within the current account.
- The capital account involves investments (such as an Indian buying land in the US, or a Japanese firm investing in the Indian stock exchange) as well as exchange of loans between India and other countries.
- It refers to export and import of services such as an Indian company selling software to an American firm, or a European bank.
- It is done by providing financial services to some Indians, or simply Indians working abroad sending back money to their families in India.
Fluctuation in Rupee’s Exchange Rate
The trigger can come from several directions.
- Crude oil prices go up sharply
- India imports 80% of its oil, the fallout would be that it would need more dollars to buy crude oil in the international market.
- It weakens the rupee because India’s demand for dollars would have gone up while the world’s demand for the rupee stayed the same.
- This would show up as a trade deficit as well as the current account deficit in the BoP table.
- US central bank raises its interest rates
- Global investors putting their money in India (demanded rupees) would consider taking it out and investing in the US (demand dollars instead).
- Again, the rupee would weaken.
- Such a transaction would be recorded in the Capital Account.
BoP is the balance of payment which always balances. In other words, a deficit in the current account must be balanced by a surplus in the capital account, or vice versa.
- To soften the rupee’s fall, the RBI would sell in the market some of the dollars it has in its forex reserves.
The exchange rate is often taken as a marker of the relative strength of an economy.
Most developing economies tend to run deficits on their trade and current accounts. A fall can help India’s exporters — unless they importing raw materials, which would become costlier.
Prelims Take away
- Exchange Rate System
- Exchange Rate Determination