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Chapter 2:

Profile of Currency Depreciation

Recently, there has been much clamour on the depreciating Indian rupee. What is depreciation? As the name suggests, currency depreciation refers to a fall in value of one currency with respect to another. So, if the Indian rupee (INR) could buy two Sri Lankan rupees today, and could buy only 1.5 tomorrow, INR would have depreciated by 25 per cent. To put it differently, if one US dollar can buy 45 INRs today, and can buy 60 INRs tomorrow; INR would have depreciated by 33 per cent. The opposite logic holds true for a currency appreciation. But what determines the value of a currency? It is the demand and supply. If more people demand say, US dollar, the value of it goes up relative to the INR, and vice-versa.

Demand for dollar

The demand for US dollar comes from individuals and institutions that require American currency to enter into a transaction. Typically, there are four major heads through which demand for foreign currency come from. First, importers who demand foreign currency to pay for the goods they purchase from abroad. Second, individuals who travel abroad carry foreign currency to transact abroad. Foreign Direct Investments (FDI) individuals or institutions that invest money abroad to carry on business operations there. Finally, Foreign Institutional Investors (FII) (individuals or institutions) who buy foreign financial assets such as stocks and bonds. Alternatively, the supply would come from the same four categories located outside of the domestic country. These individuals or institutions would demand the domestic currency to transact in our country. Extraneous of demand and supply conditions, speculation in currency market could influence the price of the currency.

Exchange rate systems

A note on fixed and flexible exchange rate systems: Theoretically, there are two exchange rate regimes that countries may opt for however, in practice, many economies fall somewhere between the two ends. Fixed exchange rate is a system in which the central bank pegs the value of the domestic currency with respect to another, regardless of the demand and supply factors. For instance, the RBI may fix the value of a US dollar to 45 INRs. If demand for the US dollar increases, the central bank would offset the increased demand by flooding the market with excess US dollars from its forex reserves. Thus the parity of 1 US dollar = 45 INRs would be maintained. In this system, since the value of currency remains the same, there is no currency appreciation or depreciation.

Under a flexible exchange rate system, the value of currency is determined by its demand and supply. The central bank does not interfere in the market to offset demand or supply factors. Currently, the RBI follows a policy that leans more towards a flexible system.

The value of currency depends upon the economic strengths of that country. The economy of the country must generate enough surplus after meeting the domestic requirements. The Net position of the Imports & exports must be consistently showing positive balance. The GDP of the country must be fairly high. The unemployment is low and nil. Then the currency earning value will be more. If invested outside the borders brings in additional income only which further results in appreciation of reserves. Depreciation of rupee occurs in an all dependent importing economy. Its productivity is not sufficient. Investment climate is not conducive due to lack of adequate capital. Inflation is fairly high not backed up by real income. It is one of the characteristic of a developing economy to print more currency than its -gold reserves can sustain. If inflation is not checked and controlled it will be a disaster and divide the country between rich and poor tearing the economies to pieces. Inflation is like a double edged knife. In order to check inflation, at times Govt. resorts to revaluation of its own currency bringing down to its real value so that exports are encouraged to balance the receipts and payments. Rupee is no exception to the above, our Govt. often indulged by bringing in more $ by pledging the gold or encouraging inward remittances but of late foreign direct investments. But if FDI flows into the non priority sector it is more evil for the nations than anything good. Then rupee looses its value abnormally.