Why does the rupee value fluctuate and what does it mean for you?

If the rupee falls, even your blood tests can cost more!

Why does the rupee value fluctuate and what does it mean for you

When we say the rupee is fluctuating, what we mean is that its value vis-à-vis another currency is fluctuating. Traditionally, India has compared the rupee mainly with the US dollar (and the British pound, to a lesser extent) as a gauge of its financial health. 

However, this does not mean the Indian rupee is pegged to either to the dollar or the pound. In fact, it is not pegged to any currency, and that is what is at the bottom of its fluctuations. Let us explore why this is so, understand what being ‘pegged’ to a currency means, and weigh the various implications of the rupee’s volatility in our daily lives.

Floating rate

‘Pegging’, a system that India once followed but discontinued 45 years ago, is when countries ‘fix’ or ‘tie’ their currencies to a dominant currency so as to safeguard the competitiveness of their own exported goods and services.

Basically, countries – such as Saudi Arabia, Qatar, Djibouti, Hong Kong, or Cuba, to name a few – set and maintain a ‘pegged’ rate as their respective official exchange rates. The currencies of these particular countries, for instance, are pegged to the US dollar.

The Indian rupee was pegged to the British pound from 1927 to 1946 and to the US dollar from 1946 to 1975, but since then we have been following a flexible floating exchange rate system. So, unlike the Saudi or Qatari rial, the Djiboutian franc, the Hong Kong dollar, or the Cuban peso, the rupee now floats on the foreign exchange market, with the Reserve Bank of India (RBI) actively managing its value.

Most countries follow this system, with free market forces of demand and supply determining the exchange rate. In other words, free market forces determine the movements (fluctuations) of the Indian rupee.

Related: Here’s what causes the Indian rupee to fluctuate

Exchange rate

An exchange rate is the value of a nation’s currency in relation to another currency, and as such, reflects the relative demand for the two currencies among those holding them. In fact, this desire to hold one currency often leads to speculating in that currency.

If the demand for US dollars among those holding Indian rupees is more than the demand for rupees among those holding US dollars, it means the US currency is stronger than the Indian one. Thus, typically, we find that a stronger economy has a stronger currency. What ultimately determines the value and exchange rate of a currency is the level of desire to hold that currency.

This desire/demand for a currency also reflects a higher demand for goods and services of that country. Since India has separate trade relations with other countries besides the US, the rupee behaves differently vis-à-vis the currencies of these trading partners.

RBI tracks the rupee’s movements in relation to the currencies of 36 trading partner countries; this is called the Nominal Effective Exchange Rate, or NEER. NEER is a weighted index, which means weightage given to a country in the index is as per its trade volume with India. 

If this index drops, it means the rupee’s value has depreciated; if it rises, it denotes appreciation.

Related: 8 Facts about the Indian currency that will leave you amazed

Rupee movements

Like most currencies in the floating exchange rate system, the value of the rupee also depends on factors that affect the economy, many of which are interconnected. Some of the factors impacting the worth of a rupee are India’s:

  • Public debt;
  • Rate of inflation;
  • Interest rates;
  • Employment numbers;
  • Economic growth;
  • Trade deficit/surplus with major partners;
  • Equity markets;
  • Foreign exchange reserves;
  • Macroeconomic policies;
  • Foreign investment inflows;
  • Remittances;
  • Banking capital;
  • Commodity prices;
  • Printing excess money, and
  • Geopolitical conditions.

All these factors have a role in the way the rupee moves. Read on for brief explanations of how each has an impact on rupee fluctuations.

Public debt
The government needs funds to finance its various projects, but does not always have the necessary finances; when that happens, it generates funds to cover the deficit by borrowing from the public through various ways, such as selling bonds or printing new money. This is deficit financing and it can lead to public debt swelling.

The problem with inflated public debt is that it scares away foreign investors, who may worry about the government’s ability to service obligations. Debt rating (by rating agencies such as Moody’s or Standard & Poor’s) may indicate risk of default. Basically, the strength of the economy comes into question, and the rupee will depreciate. As stated earlier, typically a strong economy has a strong currency.

Printing more notes (i.e. increasing the money supply) to finance projects inevitably causes inflation. That too impacts the rupee value/exchange rate, which is explained below.

Related: What is lifestyle inflation and how does one financially plan for it?

  • Rate of inflation
    Haven’t we all heard the older generation reminisce about how they bought this and that item for what today would seem a ridiculously low sum of money? That is inflation – the drop in purchasing power of a currency over time, or the erosion of the value of that currency.

    Countries with higher inflation typically see depreciation in their currency vis-à-vis currencies of their trading partners. Say India’s inflation rate rises sharply over a month; the resultant drop in the rupee’s purchasing power would mean we pay more rupees than we did a month earlier to buy the same product from the US. In effect, the rupee has depreciated in relation to the dollar.

Related: How inflation will impact your expenses 5 years down the line

  • Interest rates
    We frequently hear of the government lowering interest rates to stoke consumer spending and push national growth. This is because a cut in repo rates can lead to bank rates falling, making borrowings cheaper; this spurs spending. (For example, lower rates on auto loans will encourage people to borrow money to buy cars).

    How rate cuts affect rupee movement is a matter of debate among experts. According to one school, as these cuts lead to higher economic growth, it can trigger higher inflation, and an uptick in inflation can become another factor that causes the rupee to depreciate.

    Others say one has to look at what other factor is dominant at the time: equity inflows, capital flows driven by monetary policies, political developments etc., and one might see the rupee gaining. Whichever way the movement, what is clear is that rate cuts do influence the value of the rupee.

Related: Recession in India: How does it impact personal finance?

  • Employment numbers
    This is another factor impacting consumer spending. A greater number of employed people means more people with steady incomes, which results in them spending more money. However, if and when demand for imported goods increases (e.g. rising oil imports), the demand for foreign currencies too goes up, thereby weakening the local currency – in our case, the rupee. Therefore, we often see rupee fluctuations even during growth periods.
  • Economic growth
    Economic growth leads to job creation, which as we saw boosts spending and causes up-and-down rupee movements. But other factors too come into play when we talk of the state of the economy, all of which influence the rupee: public debt, inflation, etc. Some of these have been discussed already; others will be explained later.
     
  • Trade deficit/surplus
    A trade deficit occurs when a country imports more than it exports. A trade deficit typically also has the opposite effect on currency exchange rates. When imports exceed exports, a country’s currency demand in terms of international trade is lower. Naturally, a lower demand for it makes it less valuable. In other words, the supply of the rupee may go up due to heavy imports and its value will fall. Conversely, when exports increase and dollar inflows are high, the rupee strengthens.
     
  • Equity markets
    Data over a decade-long period till 2017 (barring the 2012-2014 years) shows the Sensex and rupee following a similar trend, rising and falling together, though not by the same degree. Essentially, the correlation is positive. This is because the factors such as the economic outlook, trade deficit/surplus etc. that impact one directly and indirectly also influence the other much the same way

    However, experts say the primary factor is the foreign investor, who needs the rupee to invest in the Indian market, thus leading to its appreciation.

Related: 8 Handy tips for millennials investing in equity markets

  • Forex reserves
    There are many reasons why countries strive for strong foreign exchange reserves. The principal one is to maintain their currency’s value. Some other reasons are to keep its exports priced competitively, have adequate liquidity during periods of crisis, boost investor confidence, pay external debts, and provide capital to fund various sectoral programmes.

    So, a dent in forex reserves can impact any of these areas and weaken the local currency. Take for instance India’s case; though its growth is predicted to contract 1.5% in 2020-21, its rising forex reserves (USD 581.21 billion in the week ended April, 2021), is a cushion that can cover the national import bill for a year. This has helped the rupee appreciate against the dollar.
     
  • Macroeconomic policies
    A currency’s price, like any commodity, is determined by its demand and supply in the international market. When its supply increases, its value falls. It is also affected by a variety of factors prevailing at a given time, such as interest rates, international trade, inflation, and political stability. Any government policy that affects these factors will also influence rupee movement.
     
  • Foreign funds
    Sustained inflows helps curb volatility in the Indian currency market and also offset sudden exits by foreign portfolio investors, which take into account global financing costs while making short-term investment decisions. This brings stability in the markets, and helps the rupee strengthen against the dollar. Conversely, when foreign investors pull out their money, the rupee weakens.

Related: 4 Smart money moves you should make in 2021

Last words

As we have seen, currency exchange rates can impact areas such as external trade, economic growth, capital inflows, inflation, and interest rates. However, as we go about our daily lives, we typically ignore these rates because we rarely need to know them; our daily lives are usually conducted in our domestic currency.

But contrary to what we may believe, exchange rates come into focus more frequently than occasional transactions such as when travelling abroad or making import payments or sending money to someone overseas. Take for instance pharmaceuticals; India might be the world’s biggest manufacturer of generic drugs, but 67% of the total pharmaceutical raw material imports came from China in 2019. For certain drugs like antibiotics or penicillin, the raw material component is 90%.

A sustained rupee slide will make medicines more expensive as the cost of imports will go up. Even medical diagnoses will get costlier as reagents and most medical equipment are imported. Similarly, end products will become more expensive when import costs of capital goods and essential commodities such as iron and steel, coal and fertiliser rise.

But if the rupee falls and someone you know is an exporter getting paid in dollars, you can rest assured that person is going to be very happy. 




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