The Indian rupee has recently breached the 85-mark against the US dollar, with one US dollar costing Rs 85. This represents a weakening of the Indian rupee, which stood at around 61 against the dollar a decade ago. The exchange rate of the rupee against the dollar has been in a long-term decline, a trend that can be attributed to various economic factors and market dynamics.

Understanding Exchange Rates

An exchange rate refers to the value of one currency in terms of another currency. It determines how much of one currency is required to buy another currency, such as the rupee's value in terms of the US dollar or the euro.

·     For example, if the exchange rate between the Indian rupee and the US dollar is Rs 85, then one would need 85 Indian rupees to purchase one US dollar.

Exchange rates can fluctuate over time based on a variety of factors, including trade balances, investment flows, inflation rates, and government policies.

·        In the case of India and the US, changes in the demand for each other's currencies in the foreign exchange market directly impact the rupee's exchange rate against the dollar.

Determinants of Exchange Rates

Trade in Goods: One of the primary factors that influence exchange rates is trade between countries. When a country like India imports more goods from another country, such as the United States, it needs to acquire foreign currency (in this case, US dollars) to pay for those imports.

If India imports more from the US than it exports, the demand for US dollars will exceed the demand for Indian rupees, which causes the rupee to depreciate. In other words, more rupees are needed to purchase one US dollar.

Trade in Services: Similar to goods, services such as tourism, education, and software outsourcing also play a role in the demand for currencies. If Indians purchase more services from the US than Americans purchase from India, the demand for the US dollar will rise, putting downward pressure on the value of the rupee.

For instance, if more Indians travel to the US for vacation or education, the demand for the US dollar will increase, causing the rupee to weaken.

Foreign Investments: Foreign investments also affect exchange rates. If foreign investors, particularly Americans, invest more in India than Indian investors do in the US, the demand for Indian rupees will rise, which will cause the rupee to appreciate. On the other hand, if American investments in India decrease or if Indian investments in the US increase, the demand for rupees will fall, leading to a depreciation of the rupee against the dollar.

Factors Affecting Demand for the Rupee

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Tariffs and Trade Barriers: Government-imposed tariffs and trade barriers can significantly impact the demand for a currency. For instance, if the US imposes high tariffs on Indian goods, it would make Indian products more expensive and less attractive to American consumers. As a result, the demand for Indian goods would decrease, leading to a lower demand for the rupee. The reduced demand for rupees would weaken the currency, and the exchange rate of the rupee against the dollar would decline.

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 Inflation Rates and Economic Conditions: Inflation is another critical factor that influences exchange rates. When a country experiences higher inflation than its trading partners, the value of its currency erodes faster. For example, if India has an inflation rate of 6% while the US experiences zero inflation, the real value of the Indian rupee would decrease relative to the US dollar. This disparity in inflation rates affects investment decisions. Foreign investors might find it less attractive to invest in India if the inflation rate is high, as their returns would be eroded by inflation. As a result, the demand for the rupee would decrease, causing it to weaken against the dollar.

§  In contrast, if the US experiences a lower inflation rate than India, American investments might become more attractive. Investors could seek higher returns in the US, causing a capital outflow from India. This would reduce the demand for rupees and increase the demand for US dollars, leading to a further depreciation of the rupee.

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Capital Flows and Investor Confidence: In addition to inflation, investor confidence plays a significant role in determining the demand for a currency. If investors believe that India’s economic conditions are deteriorating or that there are risks associated with investing in the country, they may pull their investments out of India. This could lead to a reduction in the demand for the rupee, causing it to lose value against the dollar. Conversely, if India’s economy is perceived to be growing and investment-friendly, the demand for the rupee would increase, strengthening the currency.

The Current Weakening of the Rupee

1. Global Strengthening of the US Dollar: The US Federal Reserve has raised interest rates in recent years, making the dollar more attractive to investors. Higher rates provide better returns on US-denominated assets, increasing the demand for the dollar. The US economy has shown robust growth, further driving the demand for the dollar. As the dollar strengthens, more rupees are required to purchase a single dollar, leading to the rupee's depreciation.

2. India’s Trade Imbalance: India imports more goods than it exports, leading to a higher demand for foreign currencies, particularly the US dollar. To pay for these imports, India needs to acquire dollars, putting pressure on the rupee.

India is a major importer of oil, which requires payments in US dollars. As global crude oil prices rise, India’s demand for dollars to pay for these imports increases, exacerbating the rupee’s depreciation.

3. Inflationary Pressures in India: India’s inflation rate has been higher than that of many developed countries. When inflation is higher in India, the real value of the rupee erodes faster compared to other currencies, making the rupee less attractive to foreign investors.

Higher inflation means lower purchasing power for consumers and businesses in India. For foreign investors, this erodes potential returns, leading to reduced investments in the Indian economy. As a result, there is less demand for the rupee, putting additional pressure on its value.

4. Capital Outflows: As inflation increases and the investment environment becomes less attractive, foreign investors may seek higher returns elsewhere, particularly in economies with lower inflation or more favorable conditions.

When foreign investors pull their investments out of India and move them to other markets, the demand for the rupee decreases, while the demand for other currencies (such as the US dollar) increases. This shift in capital flows further weakens the rupee.

Reserve Management by the Reserve Bank of India (RBI)

·         Foreign Exchange Reserves: The RBI uses its foreign exchange reserves to intervene in the market and prevent excessive depreciation of the rupee. However, if the rupee continues to weaken despite interventions, the central bank may deplete its reserves, which can affect India’s overall economic stability.

·         Interest Rate Differentials: The RBI’s monetary policy, including interest rate changes, can impact the demand for the rupee. If Indian interest rates are lower compared to global rates, it may lead to capital outflows, putting downward pressure on the rupee.