Rupee Vs US Dollar: How the Exchange Rate is Determined and Its Impact

All of us have seen 20% increase in the value of dollar against rupee within a year and it is fluctuating these days within a small range. Someone has asked in the comments section about what determines the exchange rate and how it is fixed and I would like to provide some of my thoughts in relation to that.

What determines US Dollar exchange rate?

There is nothing extravagant to tell you about this as the rate is determined by market forces just like how the price of goods and commodities is fixed. The value of any currency is based on the demand for it. If the people buy more of a particular currency, value of that currency increases vice versa. The same thing holds true in case of US Dollar Vs INR as well. There are few other factors that play a role in determining the exchange rate particularly when you leave the currency value to the market forces and I will list them below.

Growth of the Economy
Inflation
Strength of the Economy including Export and Import
Employment / Unemployment
Government
Public Debt
Interest Rates
Sometimes speculation and fear.

Again all these factors either increase or decrease the demand for US Dollar or any other currency. If all the factors mentioned above are favorable, people across the world get confident about the stability of a particular country and investment climate, which in turn creates the demand for the currency.

Example: Rupee appreciated significantly in 2006 – 2007 and the first seven factors I have mentioned above were the reasons for the Rupee appreciation since India had stable government with favorable economic climate. USA and other multi-national companies started investing in India and they bought more Indian Rupees and the demand for rupee increased which in turn appreciated the rupee value.

What if a country does not have all these?

People will not have confidence in that country and the demand for the currency will come to a halt and then we will see a list of failed nations. Example: Zimbabwe. You might have read in news that a loaf of bread in Zimbabwe cost 1 million Zimbabwean dollar which means nobody values that currency in essence.

But what about the eighth factor speculation and fear? That’s what made the US Dollar appreciate 20% versus most of the international currencies in 2008 – 2009.

US Dollar Appreciation

To recap, I have mentioned that Demand for the currency increases the value of that particular currency. So, what made the people to demand for more US Dollar? That’s where speculation and fear came into play and I list out few points that were responsible for recent US Dollar appreciation.

1. During tough economic times, people get scared and they start moving all their foreign currency assets to more stable currency like US Dollar.

2. US Based Mutual Funds, Hedge Funds and stock investors played a huge role as well. US Funds invested huge amount of money in India during 2003 – 2007 period, but the funds saw a huge redemption pressure due to the fear of retail investors in US. People invested in mutual funds and hedge funds panicked and started redeeming the units and the Funds were in a huge liquidity crisis. So, they started dumping the Indian stocks and converted all the currency in to US Dollar which created so much demand in a quick time which in turn increased the value of dollar.

3. International currency traders and speculators wanted to take advantage of the rising value and they started buying more and more US Dollar.

Market Forces Vs Central Bank

While most of the countries let the market forces (Demand and Supply) to determine the currency value, some countries like China had fixed currency value for a long time before easing control over it though with a limited scope. Main reason for that was to have a stable balance of payment. Even RBI can regulate the exchange rate to an extent by adjusting the foreign exchange reserves.

Impact of Exchange Rates:

Exchange rates impact in many ways starting from reduced sales for companies to more buying power for individuals. I will explain this with couple of examples.

Exports and Imports get affected

Strong dollar reduces the export value of US Companies and likewise strong rupee reduces the export value of Indian companies. This is what happened in 2007 – 2008 with Indian companies particularly in IT and Textile sector. Example: Tirupur is the Textile Capital of India and let’s take a company called ABC Textiles which makes inners. Assume ABC had agreed to supply 10 inners to Macy’s in US @ $100 per piece in 2004 when the Rupee value against the dollar was 46. ABC would have earned Rs.46000 in 2004 by supplying 10 inners. But suddenly the Rupee value increased and in 2007 Rupee value was 40 against a US Dollar (You are able to buy 1 dollar by giving Rs.40 instead of Rs.46). ABC would now earn just Rs.40000 for supplying the same 10 inners and it gets affected by reduced revenues.

Strong currency makes the imports cheaper. Take another example where KS Oils imports 10 litre’s of oil from US Company US Oils @ $10 per litre in 2004 when the exchange rate was Rs. 46 Vs US Dollar, which means KS Oils imported 10 litre’s of oil by paying Rs.4600 (100 * 46). In 2007 rupee value has increased and the same 10 litre of oil now costs KS Oils only Rs.4000. So, exchange rates have its effect on imports and exports.

Buying Power

Assume a traveler from India visited US in 2004 with Rs. 46000. He could have bought goods worth $1000 in 2004. But assume the same traveler visited US again in 2007 with the same Rs.46000. In 2007 he could have bought goods worth $1150. Of course there could have been either increase or decrease in prices of individual items based on inflation or deflation. But the essence is, exchange rates affect buying power as well.

I have also uploaded a presentation on rupee appreciation and it would be useful if you want to know more. Readers can access the file at the following link to have additional understanding.

http://issuu.com/kumaran1978/docs/rupee_appreciation

Impact of Exchange Rate on Stocks

As I said above strong currency will reduce the sales and it will have an impact on company earnings particularly when company operates across many geographics. Example: When rupee value appreciated in 2007 - 2008, all the Indian IT, Pharma and Textile exporters faced huge foreign exchange loses and it reduced the earnings and thus the share price. Now, the rupee value against dollar has decreased and all these companies enjoy more earnings due to better foreign exchange rate. Hope I provided a detailed account of exchange rate determination and its impact and look forward to your comments.

Kumaran Seenivasan
www.stockanalysisonline.com