Introduction

Before we talk about rupees appreciation or depreciation we need to understand what is Exchange rate? In a simple word, how much one currency is worth in term of another currency? For example if we can buy $1 in 40, the exchange rate for the two currencies would be $1 = Rs 40 There are two types of exchange rate: Fixed and Floating. Some countries have fixed exchange rate systems while some have floating. As the name suggests, the fixed exchange rate doesnt fluctuate because of government intervention. The floating exchange rate, on the other hand keeps on changing continuously just like the stock market. Thus the government intervention is almost negligible. So, which type of exchange rate system does India have? In India, we have a Managed Floating Exchange Rate System. This means that the Indian government intervenes only if the exchange rate seems to go out of hand by increasing or reducing the money supply as the situation demands. Lets first see two very commonly used terminologies: Rupee Appreciation & Rupee Depreciation (instead of using the word currency we are using rupee for the Indian context and explain the fluctuation with respect to dollar). When rupee is said to be appreciating it means that our currency is gaining strength and its value is increasing with respect to dollar. However, when rupee depreciates it means our currency is getting weaker & its value is falling with respect to dollar. You can understand it with the following example: Suppose, currently, the exchange rate is Rs. 45 = $1, 10 months later, either of the following two cases can happen Case1: The exchange rate is say Rs. 40 = $1. This means rupee has appreciated or gotten stronger by approx. 11% and you would be paying less to for a dollar Case2: The exchange rate is at Rs. 50 = $1. This means rupee has depreciated or gotten weaker by approx. 11% and you end up paying more for a dollar.

Why does Rupees appreciate or depreciate?

Rupees appreciation or depreciation against the dollar depends on the change in demand and supply for both the currencies. If the demand for rupee is comparatively high, rupee appreciates; if low, it depreciates. The important question here is what factors drive the demand for a currency? They are: Interest Rate: A demand for a currency is hugely dependent on the interest rate differential between two countries. A country like India where int. rate is around 7-8% experiences greater capital inflow as investors get better return than what they might get in US. (with Interest rates of 2-3%). This results into rupee appreciation. Inflation Rate: The demand for a countrys goods & services by the foreign buyers would be more if the inflation rate is lower in that country compared to other countries. Higher demand for goods & services would mean higher demand for that currency resulting in the appreciation of that currency. For instance if Indias inflation rate is lower than that of Zimbabwe then the demand for our goods, services and currency would be higher than that for Zimbabwes. Export-Import: If a country is exporting more than its imports from other countries, then this would mean higher demand for that currency, causing appreciation of that currency against others. Trading in currencies in the Forex market: The exchange rate fluctuates minute by minute because of speculative trading in the Forex market. Though trading in Forex market causes fluctuations in the exchange rate, over a period the change is backed by the fundamental factors like the growth potential in the economy, interest rate differential and the inflation rate existing in different countries. In a manage floating exchange rate system like India the government purchases rupee in exchange for the foreign currency to increase money supply in the economy which leads to depreciation of the home currency. Conversely, it purchases foreign currency in exchange for rupee to reduce the money supply in the economy leading to appreciation of the home currency.

Analysis
Impact of Rupees appreciation or depreciation: Impact on economy: Exchange rate fluctuation has a significant impact on the overall economy of a country. Rupee appreciation against US dollar is an indication of the strengthening of Indian economy with respect to US economy. Impact on foreign investors: If a foreign investor invests in Indian stock market and even if its value doesnt change in 1 year, hell earn profit if rupee appreciates and make a loss if it depreciates. You can understand this with an example: Suppose an FII Invests Re. 1 Cr. in the Indian stock market and at an exchange rate of $1 = Rs. 50. So, the amount invested is $200,000. Suppose, after 1 year, even if the value of investment doesnt appreciate the foreign investor can earn a profit if the exchange rate has changed to $1 = Rs. 40 (Rupee appreciation) If the investor sells his investment and converts the currency, he would get $ 250,000. So, he would earn $ 50,000 as a profit thanks to a change in the exchange rate i.e. rupee appreciation So, a continuously appreciating rupee would lead to greater investment by the FIIs. Impact on industry/companies: Appreciation of the rupee makes imports cheaper and exports expensive. So, it can spell good news for companies who rely on import of goods like heavy machinery, technology, microchips etc. According to reports by Associated Chambers of Commerce and Industry of India (ASSOCHAM) sectors like Petro & Petro Products, Drugs & Pharms and Engineering Goods which have import inputs of as much as 77%, 19% and 21% respectively would stand to gain the most if rupee appreciates. They would have to pay less for the imported raw materials which would increase their profit margins.

Similarly, a depreciating rupee makes exports cheaper and imports expensive. So, it is welcome news for sectors like IT, Textiles, Hotel & Tourism etc. which generates revenue mainly from exporting their products or services. Rupee depreciation makes Indian goods & services cheaper for the foreign buyers thus leading to increase in demand and higher revenue generation. The foreign tourist would find it cheaper to come to India thus increasing the business of hotel, tours & travel companies. Exchange rate appreciation and its impact on IT industries: Indian IT sector is dependent on foreign clients, especially US, for more than 70% of its revenue. When an IT company gets a project from a client it pre-decides on the length of the contract and the cost of the project. The contracts with US clients are usually quoted in dollars term. So, the fluctuation in the exchange rate can bring a considerable difference in the performance of a company. Take the example of Infosys results between 2007 and 2008 to understand the impact that the fluctuation in exchange rate can have on the performance of a company. The income of Infosys, in 2008, increased by 34.1% to $ 3912 million but because of rupee appreciation of 11.2%, from Rs. 45.06 to Rs. 40, in rupee terms, its income increased only by 19%.

Rupees /US$ exchange rate and its effect on Foreign Institutional Investor (FII)

Rs./US$ exchange rate and its effect on FII

80000 51

70000

49

60000

47

50000

45

40000

43

30000

41

20000

39

10000

37

200001 6789

200102 8151

200203 6014

200304 15699

200405 15366

200506 21453

200607 29829

200708 62106

200809 23983

200910 70139

201011 61851

35

FII

Rs/US$ exchange rate 45.6844 47.6919 48.3953 45.9516 44.9315 44.2735 45.2849 40.241 45.917 47.4166 45.5868

Rs./US$ exchange rate

FII (US$)

Rupees /US$ exchange rate and its effect on Export

Rs./US$ exchange rate and Export

300000 51

49 250000 47 Rs./US$ exchange rate 200000 45 Export (in US$)

150000

43

41 100000 39 50000 37

200001

200102

200203

200304

200405

200506

200607

200708

200809

200910

201011

35

Export

44560.3 43826.7 52719.4 63842.6 83535.9 103090.5126414.1162904.3182799.5178751.4254402.1

Rs/US$ exchange rate 45.6844 47.6919 48.3953 45.9516 44.9315 44.2735 45.2849 40.241 45.917 47.4166 45.5868

Rupees /US$ exchange rate and its effect on Import

Rs./US$ exchange rate and Import

400000 51

350000

49

300000

47

250000 Import (in US$)

45

200000

43

150000

41

100000

39

50000

37

200001

200102

200203

200304

200405

200506

200607

200708

200809

200910

201011

35

Import

50536.5 51413.3 61412.1 78149.1 111517.4 149166 185735.2251439.2298833.9288372.9 352575

Rs/US$ exchange rate 45.6844 47.6919 48.3953 45.9516 44.9315 44.2735 45.2849 40.241 45.917 47.4166 45.5868

Conclusion

Rs./US$ exchange rate

after studying the various demand and supply factors, following two scenarios come into the conclusion:

First Scenario: Rupees Depreciation This scenario is likely to occur if oil prices continue to rise or if FII money exits because of a crisis of confidence. Based on past evidence, even a relatively orderly outflow of USD 15 billion of FII money over a year could result in the INR depreciating by 2230%. This would imply an exchange rate in the range of INR 5560 to USD 1. It could get even worse if the flight of capital were to take place over a shorter period, which would cause massive concern among businesses and the government, since it would imply a higher cost of petrol, diesel, and petroleum products in India, leading to even higher food prices and Consumer Price Index. The current account deficit would balloon and the rising inflation could create a vicious cycle. First Scenario: Rupees Appreciation This scenario is likely to occur if the FII money continues to flow in and FDI levels improve. The stock markets will climb and there will be a rise in demand for INR. An appreciating Rupee will make imports cheaper and lead to better managed deficits and inflation. It must be pointed out that Rupee appreciation would erode Indias cost advantage in the export sector and negatively affect the booming ITES sector as well as the textile sector and this in turn would invite government intervention. This is what happened just before the onset of the 2008 financial crisis when the USD-INR touched 39 and the Indian government repeatedly intervened in the currency markets to halt the appreciation of the Rupee.