The Indian Rupee has depreciated significantly against the US Dollar and reached record lows last week. Why is this happening and imageswhat does this signify? This post talks about the dynamics of the rupee and reviews probable reasons for this depreciation.

Exchange rate for any currency pair is determined by the buying and selling pressure of the respective currency with respect to the other. If the market does not think positively about a currency then there is a downward pressure on that currency. The movement of rupee from 1991, when India changed from a fixed rate system to a managed floating rate system has been a roller coaster ride.

The long-term currency movement is determined by various factors.

Balance of Payments: BoP is an account of all monetary transactions between a country and the rest of the world and is the sum of current account and capital account. A positive BoP implies an appreciating pressure on the currency.

Current Account: A country running a current account surplus or positive net exports (exports – imports) exerts a positive force on the currency (Likewise, the currency depreciates with a current account deficit)

Capital Account: Capital Account can more than offset the difference in Current Account of a country. This means that there can be a BoP surplus (courtesy high Capital Account) even if the Current Account is negative. The surplus in turn increases the forex reserves of the country. Currency of a country appreciates with the rising capital inflows.

Inflation: Higher inflation leads to central banks increasing policy rates which invites foreign capital on account of interest rate arbitrage. This could lead to further appreciation of the currency. However, it is important to differentiate between high inflation over a short-term versus a prolonged one. Over short-term foreign investors see inflation as a temporary problem and still invest in the domestic economy. If inflation becomes a prolonged one, it leads to overall worsening of economic prospects and capital outflows and eventual depreciation of the currency. India’s inflation started rising around 2007 leading to RBI tightening policy rates. This led to higher interest rate differential between India and US leading to additional capital inflows. It is important to understand that at that time investors did not feel inflation will remain persistent and thought it to be a transitory issue and could be tackled by monetary policy. However, as inflation remained persistent and became a more structural issue investors reversed their expectations on Indian economy.
Interest Rate Differential: Based on the interest rate parity theory, currency depreciates for countries having higher interest rates. If this does not happen, there will be a case for arbitrage for foreign investors. The reality is far more complex as higher interest rates could actually bring in higher capital inflows putting further appreciating pressure on the currency. In such a scenario, foreign investors earn both higher interest rates and gain on the appreciating currency. This could lead to a herd mentality by foreign investors posing macroeconomic problems for the monetary authority.