Fall in Indian Rupee against dollar. How does a value of currency drop and rise?

We invented money and we use it, yet we cannot understand its laws or control its actions. It has a life of its own."
- Lionel Trilling, American literary critic.

  Money is not an organic creature but its value keeps changing with the society and its economic conditions. One rupee in 1947 is not the same as one rupee today, both in terms of appearance and purchasing power.

The value of a country's currency is linked with its economic conditions and policies

How does it work? 

There are many economic factors, which decide the value of a currency. A currency will tend to become more valuable when its demand is higher than supply. It is the basic theory.

The value of a currency, like any traded goods or services, depends on demand and supply. If there is more demand of dollars in the currency market and is not adequately matched by the supply, other things remaining equal, the rupee price of dollar will go up or the rupee will depreciate. Conversely, if the supply of dollar is higher than the demand, the rupee will appreciate. We are referring to dollar as it is the most preferred hard currency for cross-border transactions

If a country exports more than it imports, the currency will tend to appreciate and vice-versa. Cross-border transition in the goods and services market is recorded in the current account in the external accounts of the country, also known as the balance of payment.

Economic factors which decide the value of a currency

Stock market performance

It is a known fact that Indian stock market is dominated by overseas investors. When the economy is performing well and stock market is performing better than other countries, overseas investors will become heavy investors here. To invest here, they require rupee. This will increase the demand for rupee and will result in higher value for rupee. On the other hand, when these investors are pulling money out of Indian stock market, rupee will be depreciated. Indian markets are in a bad shape for the last 1 year. The sentiments after the US downgrade and the European crisis etc. resulted in overseas investors selling in India and buying dollars.

In a bad performing market, when there is depreciation in rupee, it will bring down the overseas investors real returns. So they will start selling, which will again deepen the situation.

Despite all the problems in the US, the dollar is still the safest paper currency in the world! So, there is more demand for dollar in volatile condition like this. This will add to the rupee depreciation.

Very high prices for gold have created panic among investors and fearing a bubble there, investors started moving towards dollar. This demand in dollar is also causing depreciation of rupee.

 

Inflation

Another factor affecting the currency value is inflation. We are experiencing very high inflation rate in India now. This will decrease the purchasing power against other currencies. This will leads to depreciation of the currency.

Current account deficit

Current account deficit occurs when a country’s total import exceeds the total exports. This makes the country, a net debtor to the rest of the world. A high deficit indicates, we are doing more trading outside the country than it’s actual earning inside the country. This is not good for the country because, the country needs to buy more foreign currency. More demand for the foreign currency will reduce the value of that country’s currency.

India’s current account deficit is more than the expected level now and this also contributes to the depreciation of Indian rupee.

Why and how RBI control exchange rate?

RBI will interfere in this area because a steady value of rupee is essential for the orderly growth of the economy. A depreciating rupee will harm oil marketing companies, and other import oriented businesses. This may help the software companies and other exporters, who get their payment in dollars.

RBI will be watching the position and interfere to stabilize the currency value. In case of depreciation, RBI will sell foreign currency from the reserve and this will help in arresting the fall of rupee to some extent.