Presented by:

Abhishek

Chandrakant

Piyush

Neelutpal

Tarun1

Introduction

• The exchange rate is a key financial variable that affects decisions made by foreign exchange investors, exporters, importers, bankers, businesses, financial institutions, policymakers and tourists in the developed as well as developing world.

• Exchange rate fluctuations affect the value of international investment portfolios, competitiveness of exports and imports, value of international reserves, currency value of debt payments, and the cost to tourists in terms of the value of their currency.

• Movements in exchange rates thus have important implications for the economy’s business cycle, trade and capital flows and are therefore crucial for understanding financial developments and changes in economic policy

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Genesis of the Rupee-Dollar relationship

• The Rupee-Dollar parity of 1947: When India achieved independence in 1947, there were no external borrowings on India’s balance sheet! The exchange rate as on 15 August 1947 was 1 US$ = 1 INR. With the introduction of five year plans, Indian government needed foreign borrowing and this required the devaluation of the Rupee. The trend was exacerbated by the Indo-China war of 1962 and the Indo-Pakistan war of 1965 which forced the government to further devalue the Rupee as the country was in dire need of USD for importing weapons

• Devaluation during the high inflation period of 1970s: In the year 1966, under the prime minister-ship of Mrs. Indira Gandhi, inflation was increasing at an unprecedented rate. This was also a time when India was under immense pressure from the US to devalue the Rupee to safe-guard the aid received by India from the US. This led to the Rupee being devalued to 1 USD=7 INR.

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• Devaluation after the economic liberalization of 1991: The economic liberalization in 1991 under the prime minister-ship of Narsimha Rao brought with it a sharp devaluation of the Rupee. At that time the Indian Forex reserve dropped to multi-year lows and a point came when India had only enough forex to be able to pay for 3 months of Import bills! To fill in this gap India borrowed large amounts from the International Monetary Fund’s (IMF) with an obligation to devalue the Rupee. The Rupee hit new lows with 1 US$ = 24.58 INR by the early-nineties from Rs.16.31/1 USD towards the end of the previous decade

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• The strong dollar period of 1980s: After 1970, USD grew stronger against the Rupee under the incompetence of Indian politics coupled with robust economic growth in the US. The exchange rate in 1970 was 1 USD= 7.47 INR, which rose to 1 USD=8.4 INR in 1975, after the political uncertainty following the assassination of Mrs. Gandhi in 1984. The next round of weakness in the Rupee came in the wake of the Bofors scam which toppled Rajiv Gandhi’s government plunging the Rupee to new lows of 1 USD= 12.36 INR in the year 1985. In the year 1990 this rose to 1 USD =17.5 INR

Exchange Rate Policy since 1947

• From 1947 to 1971, the Indian Rupee had a fixed exchange rate under the per value system of the IMF

• From 1971 to 1975, exchange rate of the rupee was pegged to the value of pound sterling, and from 1975 to 1991, to a basket of currencies.

• Partial convertibility of rupee, on current account, was introduced in 1992, and full convertibility in 1993

• Since 1993, exchange rate is determined by the market forces of demand and supply (Floating Exchange Rate system)

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Nominal Effective Exchange Rate (NEER)

• The nominal exchange rate is simply the price of one currency in terms of the number of units of some other currency. This is determined by flat in a fixed rate regime and by demand and supply for the two currencies in the foreign exchange rate market in a floating rate regime.

• It is 'nominal' because it measures only the numerical exchange value, and does not say anything about other aspects such as the purchasing power of that currency. In a floating rate regime, an increase in the value of the domestic currency against other currencies is called an appreciation, while a decrease in value is called depreciation.

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Real Effective Exchange Rate (REER)

• To incorporate the purchasing power and competitiveness aspect and, therefore, make the measure more meaningful, real exchange rates are used. The real exchange rates are nothing but the nominal exchange rates multiplied by the price indices of the two countries.

• This means the market price level of goods and services, given by indices of inflation. So if the price level in the US is higher than the price level in India, then the real exchange rate of the rupee versus the dollar will be greater than the nominal exchange rate

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Purchasing Power Parity Theory

• Exchange rates adjust to make goods and services cost the same everywhere

• An application of the law of one price

• If the rate of inflation is much higher in one country, its money has lost purchasing power over domestic goods. Currency depreciation to restore parity with prices of goods abroad

• Absolute Purchasing Power Parity- The equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two countries.

• Relative Purchasing Power Parity- The changes of exchange rates are proportional to the relative changes of two countries’ prices in a certain period.

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Theory of Interest Rate Parity

Covered Interest Rate Parity

• The premium or discount ratio of the forward exchange rate equals the difference between two countries’ interest rates.

• If home interest rate is higher than foreign interest rate, there will be a premium in the forward exchange rate.

• If home interest rate is lower than foreign interest rate, there will be a discount in the forward exchange rate.

Uncovered Interest Rate Parity

• The expected changing ratio of future exchange rates equals to the difference between two countries’ interest rates.

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Balance of Payments Approach

• The balance of payments consists of a current account and a financial and capital account whose sum is 0.

• The current account is mainly determined by exports and imports.

• The capital and financial account is mainly determined by home interest rate, foreign interest rate and the expectation of future exchange rate

• The equilibrium exchange rate can be depicted as a function of the Balance of Payment equation which constitutes all these factors.

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Asset Market Approach

• Monetary Approach- In the monetary approach the exchange rate for any two currencies is determined by relative money demand and money supply between the two countries.

• The portfolio-balance approach allows relative bond supplies and demands as well as relative money-market conditions to determine the exchange rate.

• The essential difference is that monetary-approach models assume domestic and foreign bonds to be perfect substitutes, whereas portfolio-balance models assume imperfect substitutability

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Interest Rate

• When interest rate in home country is higher than other country, more foreign investor will be attracted to invest in home country to make capital gain. In this case demand for home country’s currency will increase and may cause it to appreciate.

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Balance of Payment

• When in country’s balance of payment the export is greater than import we call there is surplus. Normally it has seen the country which face the surplus there currency value increase than country which make deficit.

• The other way to look at it is that when exports are more than imports, more importers will sell foreign currency that received by exporting which increases demand for home currency which results in appreciation of currency.

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Money Supply and Inflation

• At the time central bank of country will print more money, the supply of money will increase in the market. Which results in increase in purchasing power of customer also and which ultimately increases inflation.

• Since inflation and currency value are inversely related, with increase in inflation currency depreciates.

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Economic Growth

• When the economic growth of a country is high FII would divert there investment to such growing economy by selling their investments in other countries, which increases supply of currencies of those countries of which FII’s are selling investment causing it to depreciate and the currency of country, in which FII’s are diverting their investment, appreciates.

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Foreign Debt

• With borrowing comes an obligation to repay the money along with interest. So when a country borrows more foreign debt it need more foreign currency to repay that loan, which makes it to sell more home currency to buy foreign currency resulting in depreciation of home currency.

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Basically all these factors are linked to each other.

For example:• When home currency appreciates too much that affects exporters because

now when they receive their payments in foreign currency, after it conversion in home currency they receive less amount because of increased home currency value. At this point RBI intervenes and sells home currency to reduce it’s value, now when RBI is selling home currency it increases supply of home currency which results in inflation, now to control inflation RBI increases interest rates, as interest rates increases it affects economic growth as it increases cost of borrowing, so companies prefer to borrow from foreign markets as it’s cheaper than home loans which results in increased foreign debt, which disturbs balance of payment.

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Short Term Factors• Central bank intervention: Buying and selling of foreign currency in the

market by the Central Bank with a view to increasing the supply or demand, there by affecting the exchange rate, is known as intervention.

• Export receipts and import payments: The difference between the total receipts from export bill realizations and import payments on a given day in a country determines the exchange rate to some extent.

• Foreign investment flows: Both foreign direct and portfolio investment inflows and outflows affect the exchange rates.

• Political factors: Factors like war. Announcement of election results, oil price increase etc will cause exchange rate fluctuations.

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• Speculation: If a few big speculators start buying a currency in an aggressive manner, others may follow suit. Thus, the demand of the currency may increase.

• Capital Movements: Movement will be caused by external borrowings and assistance. Large-scale external borrowing will have favorable effect on the exchange rate of the country’s currency.

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