This graph shows the time series of Indian rupee since 2003 till now (march 2016). In January 2003, one US dollar was exchanged for 47.96 rupees, and at the end of year the exchange rate fell to the value of 45.57 rupees. The main cause behind this appreciation of Indian currency was the global fall in price of US dollar against most currencies, rupee happened to be one of them. The dollar's fall added to the upward pressure on the rupee that had been building up due to acceleration of foreign-exchange inflows. More than $30 billion were added to the foreign-exchange reserves in 2003, this move created demand-supply imbalance and the supply of dollars in India was more than its demand. As a matter of fact, rupee continued to appreciate till the end of 2004. To prevent the rupee from appreciating the RBI tried what is called the "sterilization" of dollars. It bought dollars from the market and issued rupees against them in the form of government securities. But when the dollar started falling on its own, the central bank couldn't prevent the rupee from rising. This shows that even though RBI has power over manipulating Indian rupee behavior, it has no power over the movement of US dollar.
Factors affecting exchange rates
There are many variables that have direct or indirect impact on the exchange rate of currency. The main determinants of Exchange rate are as follows:
Inflation Rate
A country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Inflation is closely related to interest rates, which can influence exchange rates. Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and often difficult to manage. Higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country's currency. However, higher interest rates often cause increasing inflation rates, a negative influence on the country's currency. Low interest rates spur consumer spending and economic growth, and generally positive influences on currency value, but they do not commonly attract foreign investment.
Measures to tackle inflation by RBI
A careful assessment of the manner in which inflation is evolving in India reveals that primary food articles have contributed significantly to inflation during 2006-07. At the same time, prices of manufactured products account for well above 50 per cent of headline inflation. The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its goals of growth, price stability and financial stability, rather than targeting inflation alone. In its effort to balance many objectives, which often conflict with each other, RBI looks confused, ineffective and in many cases a cause of the problems it seeks to address.
The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the rates at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected to suck out a substantial sum from the banks. In effect, while the economy is booming and the credit needs grow, the central bank is tightening the availability of credit. Whenever inflation goes beyond RBI's comfort zone 'say 6%, RBI will increase the repo rate. When repo rate is increased, lending rates by banks goes up. This will reduce amount of loans taken by the households and business people to meet their consumption and investment activities. In this way, consumption and investment comes down. In the next sequence, employment and income of the people also comes down. Because of low income, people reduce demand for commodities and hence, the price of commodities comes down because of weak demand.
In effect, inflation is brought down only after repo rate hike discourages consumption, investment and then reducing income with the people. Then in the next step only, inflation comes down. A major feature of the inflation targeting monetary policy is that it has only one target- inflation and one objective -price stability. What happens to income and welfare of the people doesn't matter for it in its pursuit for price stability. Deputy Governor of RBI, Deepak Mohanty has made a VAR (Vector Autoregression) study about the working of repo rate in India. According to his study, after an initial increase in repo rate, income reduces after three quarters and inflation reduces two more quarters after the reduction in income.
Central banks generally have the view that for ensuring growth, price stability gives a necessary level playing field. If price level goes high, there can't be savings, investment and production. Hence, price stability is a precondition for growth and it should be maintained with right vigilance. They recognize the conflict between growth and stability but like to preserve the latter more.
Interest rate
All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely, if ever, exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect and impact the overall financial condition of a country in respect to that of other nations.
Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.
Cash Reserve Ratio and Repo rate as a monetary tool
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults of the central banks. The aim is to ensure that banks do not run out of cash to meet the payment demands of their depositors. When CRR rises, more cash goes away to RBI and less is available with banks. This implies they have lesser cash to provide loans and so the cost of loans (i.e. interest rates) go up.
Whereas, repo rate is the rate at which the central bank in a country repurchases government securities (such as Treasury securities) from commercial banks. The central bank raises the repo rate when it wishes to reduce the money supply in the short term, while it lowers the rate when it wishes to increase the money supply and stimulate growth. The first thing that happens when the RBI changes the repo rate is that the so-called overnight rate is affected. The overnight rate is the rate at which the banks borrow and lend money to one another during the day. The size of the effect that a change in the repo rate has on interest rates with a longer duration depends on how expected the adjustment is. The RBI aims to make its monetary policy predictable that is why it tries to affect expectations of future monetary policy by frequently publishing forecasts for the repo rate.
Current Account
It is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. The largest component of a deficit usually a trade deficit. This simply means the country imports more goods and services than it exports. The second largest component is usually a deficit in the net income. This occurs when the country exports dividends on stocks, interest payments made on financial assets, and wages paid to foreigners working in the country. If all payments made to foreigners are greater than the interest, dividends and wages made by foreigners to the country's residents, the deficit will rise.
The last but not the least component of the deficit is the smallest, but often the most hotly contested. These are direct transfers, which includes government grants to foreigners. It also includes any money sent back to their home countries by foreigners
Economic growth and High inflation are the main reason behind the deficit in current account. There is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. India's current account deficit story is well known and reflects an overall failure to curb imports and boost exports. This leaves India dependent on foreign capital to fund the current account. It also exposes the vulnerability of India's overall balance of payment in a scenario of sudden exit of foreign capital.
Public Debt
Public debt is the debt owed by a central government. Among the non-tax sources, the major source of government revenues is public debt. Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors Political Stability and Economic Performance
Political uncertainty makes it difficult to value assets in the future, since unexpected policy decisions may quickly change the valuation of a currency. In such situations, the exchange rates tend to weakened and be more volatile. At the same time, the willingness of investors to have their money invested in the country fall sharply, because you do not know exactly which politics will be conducted in the future.