Where is the rupee headed to and how will it impact you?

Rupee weakens

by 5paisa Research Team Last Updated: 2022-05-13T15:01:52+05:30

Every time there is a major change in the exchange rate of the rupee, social media, newspaper columns and TV discussions will explode with commentary. One half will fervently argue that this is the best thing that could have happened since brown bread. You will find equally convincing arguments and data from those arguing that it was the worst that could has happened in living memory!

The latest round was just this week, when the rupee touched a new record low against the US dollar. As with everything else, the actual truth will be somewhere in between.

On May 12, the rupee fell to an all-time low of 77.59 to the dollar. Immediately, all hell broke loose and the arguments raged back and forth. But why is the rupee weakening and how does it affect us? We will get there in a little while, but first let’s understand what is the exchange rate and why is it important.

A bulk of the international trade is carried out in US dollars. So, when an Indian company buys goods from say, Japan, their bank buys the equivalent US dollars and pays to a Japanese bank, which in turn pays to the seller. To facilitate this, central banks have to buy and sell dollars. The rate at which they do this is the currency exchange rate.

The exchange rate is determined by a number of factors including the strength of the buying economy, international situations and market conditions. Sometimes, countries also take a decision to devalue their currency in order to improve their trade and internal economy.

On the other hand, countries may also by policy decision, fix a steady exchange rate for their currency, like India used to do many years back. Open economies typically let their currencies fluctuate freely within limits.

On rare occasions, such as the start of the Covid-19 pandemic or the 2008-2009 global recession, central banks can also print more money to support their economies. But they cannot keep on printing their own currency and exchange it for dollars because that will lead to hyperinflation.

The exchange rate is determined by a number of factors, global, external as well as internal. For example, if there is political instability like what is happening in Sri Lanka, then it will adversely affect the exchange rates. A positive share market, on the other hand, could hold up the exchange rates.

Interest rate changes also affect the exchange rate. Global factors like the war in Ukraine also will have a huge impact on the exchange rates. Such events will weaken other currencies (increase the exchange rate) due to the risks as well as the uncertainty it introduces in the commodity markets.

But does only the dollar exchange rate matter? Well, the bulk of global trade is in US dollars. So, the dollar exchange rate is what is most mentioned. But yes, some part of global trade does take place in other currencies, too. For example, some trade between India and Russia happens in the rouble. Some India-Japan trade happens in the yen and so on. Still, the dollar is the predominant currency in the international market.

What’s better: Weaker or stronger?

This brings us to the next important question: Is a higher exchange rate (more rupees per dollar) good or bad? The answer is, it depends. It depends on who you are and what you are doing with the currency.

For example, if you are the government of India, and buying crude petroleum, then you have to spend more rupees for the same quantity of petroleum. This means that the cost of petroleum products such as petrol, diesel, LNG, CNG, and plastics will go up. As a secondary effect, price of transport will go up. This will, in turn, increase the price of food products and so on.

On the other side, a large part of the Indian economy is based on services. Particularly, export of software services to other countries. The rupee equivalent of such income will go up even if the billing does not go up. That means incomes will go up, leading to increased spending power of certain sections of the local population.

Similarly, increased purchasing power of the dollar means that more foreign tourists could now afford to visit, leading to higher total spends here by them. Indian goods exports have just hit an all time high, meaning that it is not just the software and tourist sectors that will benefit from a higher exchange rate for the dollar.

What if the exchange rate fluctuates? Unless it is a command economy, the exchange rate will fluctuate on a daily and even shorter basis. That is healthy. The problem will be when there are wild fluctuations or as is more likely the case, dramatic drops. Take the case of Sri Lanka. The political and economic turmoil in the country has taken a heavy toll on the exchange rate of the local currency, which moved in a range of 199.5 to 364.76, a variation of 82% over the past year.

In comparison, the Indian rupee has fluctuated within a very narrow range during the same period, between 72.4 and 77.37, a variation of 6% during the year.

To be sure, while the rupee has depreciated against the US dollar, it may have gained against some other currencies. For instance, both rupee and the yen have weakened against the dollar over the last one year, but the Japanese currency has declined at a faster rate.

Foreign currency reserves

A healthy reserve of foreign currency is good for the economy and could contribute to steady exchange rates. Beyond that, there is no direct correlation between fluctuations in foreign exchange reserves and exchange rates.

source: tradingeconomics.com

India had been building up a healthy position in foreign exchange reserves, which stand at $597.72 billion. This is lower than the high of $634.96 billion in mid-January, but still higher than 2020-21, which ended with reserves of $576 billion. Some of the reserves might have been spent by the RBI in limiting the decrease in exchange rates.

Will the rupee depreciate even more?

That, like they say, is the billion-dollar question. Fortunes could be made, if you could correctly predict the movement of currencies!

The big question is not whether the currency will strengthen or depreciate, but whether it will do so within manageable limits. If you consider the long-term performance, the exchange rate has been on a steady climb over many, many years. Given the current global instabilities, it would be wise to expect this trend to continue rather than to decline.

The challenge for the RBI and the planners with the central government is to ensure that there are no rapid declines. Current economic and political trends within the country do not indicate any concern that that will happen.

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