INTRODUCTION

Exchange rate (also known as conversion rate) between two currencies is the rate at which
one currency can be exchanged for another. Exchange rates play a vital role in a country's
level of trade, which is critical to almost every free market economy in the world today.
Therefore, exchange rates are among the most monitored, analysed and governmentally
manipulated economic measures. Exchange rate matters not just on the big macroeconomic
scene but also on a smaller one. It impacts the real return of an investor's portfolio,
profitability of firms, international trade of goods and services and growth of specific sectors
amongst various other determinants of the economy.

From a fixed exchange rate mechanism when the central bank of India, RBI, played the
dominant role in determining the value of the domestic currency vis-à-vis other hard
currencies to LERMS (Liberalized Exchange Rate Management System) to a unified exchange
rate system from March 1, 1993, we have moved a long and tedious path.
The introduction of current account convertibility and move towards introduction of capital
account convertibility has helped the Rupee-Dollar exchange rate to attain more flexibility
as required by the market conditions.
There have many policy changes during the period and the most significant one being the
replacement of draconian FERA by much user friendly FEMA. The opening up of the
economy helped to attract huge inflows of foreign capital, both FDI and FII and this helped
the exchange rate to stabilize thus the Asian crisis of 1997-98 did not have a lingering
impact on Rupee-Dollar exchange rate.
Despite this the Indian rupee, which was on a par with the American currency at the time of
Independence in 1947, has depreciated by more than 73 times against the greenback in the
past 71 years. On 22 October 2018, the Indian Rupee had gone down to an all-time low of
73.693 against the US dollar. This volatility became severe in the past few years affecting
major macro-economic data, including growth, inflation, trade and investment indicating
current economic situation in their country.
Currency’s true value is its relation among value of currency, its supply and economic
growth. Merely increasing the number of tanks (printing currency) does not increase the
irrigation power (purchasing power). One has to make sure that the tanks (currencies) get
enough rain water (economic growth).

Key Factors that Affect Foreign Exchange Rates

1. Inflation Rates

Prices shoot up when goods and services are scarce or money is in excess supply. If prices
increase, it means the value of the currency has eroded and its purchasing power has fallen.

Let us say the central bank of a country increases money flow in the economy by 4 per cent
while economic growth is 3 per cent. The difference causes inflation. If the growth in money
supply is 10 per cent, inflation will surge because of the mismatch between economic
growth and money supply. In such a scenario, loan repayments will be a lesser burden if
interest rates are fixed, as you will pay the same amount but with a lower valuation.

A fall in purchasing power due to inflation reduces consumption, hurting industries. Imports
also become costlier. Exporters, of course, earn more in terms of local currency.

However, if the increase in money supply lags economic growth, the economy will face
deflation, or negative inflation. The purchasing power of money will increase when the
economy enters the deflationary state. If you think deflation will help you consume more
and enjoy life more, you are wrong.

Unless the fall in prices of goods is because of improved production efficiencies, you will
have less money to spend. If you have a fixed-interest loan to repay, your debt will have a
higher valuation. Yields from fixed-income investments made before deflation set in will, of
course, increase in value.

2. Interest Rates
Increases in interest rates cause a country's currency to appreciate because higher interest
rates provide higher rates to lenders, thereby attracting more foreign capital, which causes
a rise in exchange rates. While an increase in interest rates makes a currency expensive,
changes in cash reserve and statutory liquidity ratios increase or decrease the quantity of
money available, impacting its value. Open interest parity says that the domestic interest
rate must be higher (lower) than the foreign interest rate by an amount equal to the
expected depreciation (appreciation) of the domestic currency.

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is
earning through sale of exports causes depreciation. Balance of payments fluctuates
exchange rate of its domestic currency.

4. Government Debt
Government debt is public debt or national debt owned by the central government. A
country with government debt is less likely to acquire foreign capital, leading to inflation.
Foreign investors will sell their bonds in the open market if the market predicts government
debt within a certain country. As a result, a decrease in the value of its exchange rate will
follow.

5. Terms of Trade
Related to current accounts and balance of payments, it is the ratio of export prices to
import prices. A country's terms of trade improve if its exports prices rise at a greater rate
than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of
exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A
country with less risk for political turmoil is more attractive to foreign investors, as a result,
drawing investment away from other countries with more political and economic stability.
Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic
currency. A country with sound financial and trade policy does not give any room for
uncertainty in value of its currency. But, a country prone to political confusions may see a
depreciation in exchange rates.

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its
chances to acquire foreign capital. As a result, its currency weakens in comparison to that of
other countries, therefore lowering the exchange rate.

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency
in order to make a profit in the near future. As a result, the value of the currency will rise
due to the increase in demand. With this increase in currency value comes a rise in the
exchange rate as well.
 Income levels influence currencies through consumer spending. When incomes
increase, people spend more. Higher demand for imported goods increases demand
for foreign currencies and, thus, weakens the local currency.

 Another factor is the difference in interest rates between countries. Let us consider
the recent RBI move to deregulate interest rates on savings deposits and fixed
deposits held by non-resident Indians (NRIs). The move was part of a series of steps
to stem the fall in the rupee. By allowing banks to increase rates on NRI rupee
accounts and bring them on a par with domestic term deposit rates, the RBI expects
fund inflows from NRIs, triggering a rise in demand for rupees and an increase in the
value of the local currency.

 Also Indian rupee is tied to some of the big economies other than USA, including UK,
Germany, Netherlands, Japan and Canada. The depreciation or appreciation in the
currency any of these influences the valuation of the Indian currency in one way or
the other.
Motivation:
Indian exports have not substantially increased even though we had devalued our currency
on certain occasions. Though the views differ as to whether, how and to what extent it
might be desirable to promote competitive depreciation to suit domestic economic
interests, large depreciations have also the potential to increase credit
risk and the burden of debt denominated in foreign currencies. Downward pressures on
exchange rates and downturns in market sentiment can be mutually reinforcing and result
in higher uncovered exchange rate exposure and financial disruption.
Large exchange rate fluctuations in an environment of increased international capital
mobility affects the level of inflation predictability and the pricing of financial assets.
Unexpected fluctuations in inflation targets and expectations can exert downward pressures
on financial market valuation as drifts from the purchasing power parity rates have the
potential to generate increased uncertainty on firms’ cash flows and affect their market
value.
Broadly defined, exposure to foreign exchange risk measures the sensitivity of the firm
value, or the present value of expected future cash flows, to currency gyrations. The
negative exposure of import-oriented firms to depreciation has the potential to decrease
stock prices and increase the required risk premium. The effect is asymmetric with respect
to import oriented firms but even purely domestic firms may still suffer from currency
depreciation because of sustainable falls in aggregate domestic demand. The aggregate
impact of exchange rate variations on stock market valuation is ultimately function of the
trade imbalance within the economy.
Before liberalization, India has only one official rate that used to be determined by the
central bank of the country and market participants had very little role in the market with
regard to determination of the exchange rate. As per the new economic policy 1991,
exchange rate liberalization received maximum attention of the policy makers. In early
1990’s, the experiments with Liberalized Exchange Rate Management System (LERMS)
proved successful and slowly from dual exchange rate system the country moved to an
unified exchange rate system. By 1994, the exchange rate was by and large convertible on
current account and partially on capital account. Full convertibility of the exchange rate,
though not in place today, is on the agenda of the central banks and to show seriousness to
the issue, RBI appointed a committee to suggest roadmap for introduction of full
convertibility. The country experienced the mild contagion effect of financial crisis in
International markets and successfully sailed through the period of Asian crisis not
significantly jeopardizing the interest of the domestic economy and fall in Indian Rupee was
not high compared to other emerging Asian economies. Today the exchange rate is
determined by the market forces of demand and supply and market participants play a
dominant role in the determination of exchange rate. Dirty float has been replaced by a free
float so far the market is concerned,
though at times the central bank has to cool the excess volatility in the market with indirect
intervention like issuing policy statements. Over the years more flexibility has been provided
by the central banks to market participants including banks and institutions to operate in
the foreign exchange market. Foreign Exchange Regulation Act has been replaced by a more
friendly Foreign Exchange Management Act. Risk management system has been changing in
keeping pace with change in scenario. Other reforms in the form of deregulation of interest
rate, tax reforms, banking sector reforms, reforms in the external sector, etc. has also
helped market participants to value assets according to their intrinsic values. Liquidity has
greatly increased as the market with increase in depth of the market. International
investors’ access to the domestic market has also helped in increasing liquidity. All these
helped in better dissemination of information and hence increased the level of efficiency in
asset prices. Over the period, without adding much to the stock of external debt, there has
been a quantum jump in forex reserves. This position needs to be contrasted with the
1980s, when external debt, especially short-term debt, mounted while the forex reserves
got depleted. In fact, it is often held that, between 1956 and 1992, India faced balance of
payments constraints in all but six years, while during the last ten years, there has never
been a feeling of constraint on this account, even though the period coincided with
liberalization of external account, global currency crisis and domestic political uncertainties.