The value of the Indian rupee against USD is the foreign exchange value. The foreign exchange currency is the practice of determining the value of a country’s currency with respect to other countries in the world. But why is USD the base currency for comparison?
What really makes the Indian rupee lose or gain its value? In this article, we are going to find out.
This can be traced back to the early 1900s, when Britain was forced to borrow money due to the expense of World War One. The United States became the lender of choice for many countries willing to buy dollar-denominated U.S. bonds. This forced Britain to drop the gold standard, which put the dollar over the pound.
In 1944, forty-four countries decided that the currencies will not be linked to gold. The world’s currencies were now linked to the U.S. dollar, and this treaty was called the Bretton Woods Agreement. This decision made USD the strongest currency, which is the case to date.
Now let’s take a look at the factors that affect the value of the INR.
The basic concept is that the lower the inflation rate, the stronger the value of the currency. How does inflation affect the foreign exchange rate?
Let’s assume India’s rate of inflation is higher in comparison to the USA. This increases the cost of goods in India which incentivizes Indian individuals and organizations to import goods from the USA, which increases the demand for USD, shifting the valuation against the INR.
This will also cause the USA to reduce imports from India due to comparatively higher rates. Reduction in the supply and lack of export from India to the USA will adversely impact the INR.
Interest rate is one avenue through which central banks of each country can affect the foreign exchange rates and inflation. Let’s assume the interest rate on security bonds in India is 6%, and in the USA, it’s 3%.
This will attract investors, business people and banks to invest in India as it is more lucrative than the USA security bonds. This will cause a large influx of cash from American businesses, individuals, banks, etc., into the Indian market.
To buy the Indian securities, dollars would need to be converted to rupees, which would shift the supply curve of the USD. This finally would reduce the value of the USD compared to the Indian rupee.
As seen above, due to the relative interest rates, the foreign exchange value changes because of the influx of capital. On the other hand, capital flow is not only affected by the interest rate. India experiences an influx of capital through foreign direct investments (FDI) because of higher returns. Foreign investors invest in the Indian markets because they expect to yield higher profits than domestic markets.
Capital influx is also observed when foreign institutional investors (FII) and NRIs invest in Indian companies through the stock market. Now the similar shift in the supply of dollars causes the USD’s value to drop compared to the INR.
The foreign exchange value is affected by every factor that is important to a country. In the end, all the values are directly connected to the wellbeing and prosperity of the country in every socio-economic aspect.
That’s all folks!