Why does value of currency Change?

It was time for weekly Skype session with Apurva. I had explained her what role does currency have to play in terms of inflation. But more fundamental question remained unanswered, why does the value of currency change?

Why does the value of 1$ change?” the excitement on Apurva’s face was evident clearly. “There are many political and economic factors that govern the movement of the currency of which Interest Rates and Imbalance between Import and Export play a significant role.  In the long run the exchange rate would adjust themselves to the principal of Interest Rate Parity”, I started explaining her. Things would get more technical I knew but my challenge was to keep it as simple as possible.

Let us understand this with an example. Suppose on 1^st of January 2014 1$= ₹ 50. Interest rate in India is 5% and Interest rate in USA is 10% per year. You have ₹ 50000 with you to invest. Let us compare the output of investing the money you have in both US and India. In India at the end of the year you would get ₹ 2500 as an interest and you get 50000+2500=52500 in your hand on 1^st January 2015. If you were to invest the same amount in USA you first have to convert it to $ on 1^st Jan 2014 as banks in USA accept only $ deposits. In that case, you would have $1000 after the conversion. After you invest $1000 in US, you would get $100 as interest so that you would have $1100 on 1^st January 2015. Ideally the end value whether you invest in India or USA should be the same else it would be advantage to invest in USA as it pays higher interest. Therefore $1100= ₹ 52500 which means 1$= ₹47.72.

But this is very theoretical and may or may not hold true in short term. In short term supply/demand of Rupees/Dollar would decide the movement of the currency. India like many other countries import certain goods and commodities that it cannot manufacture e.g. Oil, iPhones. At the same time it also exports food items/handicraft items to other countries.

For imports there would be a demand of the $ (or currency of that country from which imports are made) by supplying rupees. More demand would lead to appreciation of dollar (Rupee depreciates) as we have already know that when there is more demand without increase in the adequate supply the prices would appreciate. In case of exports there would be more demand for Indian Rupee by supply of $ (or currency of the country importing from) and hence Rupee would appreciate, more supply of $ without equivalent increase in demand would lead to depreciation in prices.  So majority of the currency movement is influenced by the imbalance between imports and exports. The imbalance would cause a deficit if the imports are more than exports while it will cause surplus if exports are more than import. The deficit/surplus is called as current account deficit/current account surplus. India traditionally runs current account deficit i.e. its import bills are more than export revenue it generates. But the currency movement is not totally decided by imports/export alone.

Exports are not the only way of supply of $, there are three major sources of $ inflow.

   1.  Remittances :

Remittances are the most reliable and safest source of $ inflow. Remittances refer to the part of the money sent by Indians residing outside of India (NRIs) to their home. Kerala contributes to most of the remittances that come as an inflow in India.

   2.  Foreign Direct Investment (FDI)

This is next reliable sources of inflow. In the case of FDI foreign multinational own stake in Indian companies in bulk. There are restrictions on maximum limits these multinationals can invest in Indian companies which defers sector wise. E.g. the limit is different for retail industry vs. that of the insurance sector. The limits are decided by the government of India and passed by both floors of the parliament. Tough regulatory framework is laid down by the government which the foreign multinationals must comply in order to own the bulk ownership. The ownership can be a majority (>50%) or minority (<50%) as decided by the government. The money invested is relatively nonvolatile as the multinational would again need to follow several stringent norms in order to exit the investment.

  3.  Foreign Institutional Investment. (FII)

This form of inflow of $ is the most volatile and non-reliable source of inflow of $ that can cause extreme currency movements. In this case the foreign institutional investors (large investment firms) can directly own equity ownership in various Indian firms, much like   all retail investors, you and I. The money investment is to gain short term profit from increase in the price of the shares purchased. These FIIs can also pull out money from Indian economy if their economy is struggling and they are in need of cash. Hence this money is also referred as “Hot Money” sometimes which impacts the currency movements significantly in either of the directions.

Apart from these sources of $ inflow, the Reserve Bank of India (RBI) also keeps foreign currency in reserve for emergency purpose. It does this by buying the currency from open market time to time. It sells the $ from its reserve when it fills that the currency depreciation of rupee is becoming more volatile and moving beyond the comfort zone of RBI. There are some countries like Hong-Kong which keep their currency constant with respect to the currency of the other currency (often called as pegging of the currency) by selling /buying currency from/into its reserves. India has been following free floating currency and RBI intervenes only when it moves beyond its comfort zone.

“I now understand why does value of the currency change. From every conversation we have had so far, I can understand the fact that interest rate plays a role a critical role in the economy. I wish we had a world where there are no interest rates and we could borrow from a bank and don’t have to pay interest”, said Apurva. “Well, there exists banks that do not charge interest, we will discuss it next time”, I ended the Skype call with Apurva with a promise of taking her to a world where there is no concept of interest rates.