The Indian rupee slipped below 53 against the US dollar recently, second time in four months. The last time it touched this level was in December. It appreciated to the level of 48-49 in February.
Why does rupee fluctuate?
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.
What affects demand and supply?
The supply of dollars depends on two factors—exports and investments. When goods or services are exported, the exporter gets the payment in dollars which is converted into rupees in India, boosting the supply of dollars. On the other hand, if individuals or companies buy goods and services from abroad, they need dollars to settle the bills, leading to an increased demand of dollars.
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. This includes remittances from Indians working aboard. The other component of the external account is capital account, which records cross-border flow of investment and debt.
Why is rupee depreciating?
India runs a current account deficit, which gets compensated by the inflow on the capital account (foreigners investing in India, including direct and portfolio investments). In recent times, our current account deficit has widened and capital flows are not being able to bridge the gap. In the quarter ending December, the deficit expanded to 4.3% of the gross domestic product compared with 2.3% in the same quarter last year. As a result, the demand for dollars is high, while the supply remains low. Hence, the rupee is falling.
At the macro level, significant depreciation affects the overall confidence in the economy and policymaking becomes difficult. Importers have to shell out more rupees for the same amount of goods in dollars, leading to higher rupee price and inflation. For example, suppose an Indian buyer pays Rs 50 for an article priced at $1. If the currency depreciates to Rs 60, the buyer will have to pay Rs 10 extra for the same article, still priced at $1.
It hurts foreign investors as they get fewer dollars for the same amount of rupees realized. It also increases the liability of companies having dollar debt as they need to earn more rupees to repay the same debt. It, however, benefits exporters as goods become cheaper in dollar terms.