| How are foreign exchange rates determined? The increase in dollar value is due to the widening gap in trade deficit, high oil prices and FIIs pulling out money. How are exchange rates determined? Exchange rates between currencies can be either controlled as in the case of India prior to the reforms or left to the market to decide, as is the case now in India. In the case of controlled exchange rates, it is quite obvious that the government would fix them, so the question really boils down to what is the process by which markets determine rates. The process is really not different in its essentials from the way any market functions. The supply and demand for different goods determine what their prices are. In this case, substitute currencies for goods. Lets take the case of one foreign currency to understand how this market works. Thus, the dollar-rupee exchange rate will depend on how the demand-supply balance moves. When the demand for dollars in India rises and supply does not rise correspondingly, each dollar will cost more rupees to buy. Where does the supply of dollars come from? The supply of dollars comes from several sources. One obvious source is Indian exporters of goods and services who sell their wares in the international market for dollars. Another important source is Indian immigrant workers abroad who repatriate money to their kin at home. The third major source is investments by foreign individuals, companies or institutions in India. This could be in the form of foreign direct investment where they are using the money to create some assets in India or to buy into the equity of an existing company. It could also be in the form of portfolio investments where dollars are being brought in to buy assets in the stock markets, for instance, with the purpose of selling these assets when they appreciate in value to book a profit. While all these forms contribute to the supply of dollars, it should be obvious that the last of them portfolio investment is a relatively uncertain source, since it necessarily implies an exit of dollars at some point. That explains why such flows of capital from abroad are often described as hot flows, since they can move out very rapidly. Foreign tourists visiting India would also contribute to the inflow of dollars. What factors determine the demand for dollars? Just as exporters earn dollars, importers spend them. Imports are thus the most important source of demand for dollars. Another major source of demand is individuals or companies repatriating incomes or profits to their home countries. This would include portfolio investors as well as Indian branches of multinationals sending back some of their profits to the parent company as dividends. A third source would be Indians investing abroad, whether as firms or as individuals. Besides this, of course, the forex you buy when you travel abroad is also adding to the demand for dollars. As you can see, the factors that contribute to the demand for dollars are mirror images of those that add to their supply. What explains the rapid increase in the value of the dollar recently? As should be clear by now, this is because the demand for dollars is surging when its supply is not. A couple of factors have been particularly crucial in this. First, the trade deficit the gap between the value of our imports and that of our exports has been widening, meaning exporters are earning a smaller proportion of the dollars that importers need. The high prices of crude oil have been a large, but not the only, factor. Second, foreign institutional investors (FIIs) who had been pumping billions of dollars every year into a booming Indian stock exchange have this year been equally desperately pulling out their money thanks to the financial crisis facing them in their home market. What role do expectations play in all this? As in any market, expectations and the consequent speculation play a significant role. For instance, when there is an expectation that the dollar will rise against the rupee, exporters tend to hold back their earnings for a while in the hope of getting a higher rate when they ultimately bring their dollars in. This, of course, skews the supply-demand equation even further confirming their initial expectations and thus setting off a vicious cycle. Similarly, importers who expect to pay more for their dollars tomorrow will try and buy up as much as they can today, adding to the current demand and making the dollar rise even more. Currency traders in such a situation would also try to benefit by betting on what the future price of the dollar would be. What can the RBI do about it? With hundreds of billions of dollars in its reserves, the RBI would seem to have the ability to be a major factor in how the dollar moves. If, for instance, it were to dump a huge amount of dollars in the market, it could dramatically add to the supply and hence reduce the price. There are at least two major reasons why central banks are reluctant to do this. First, they do not like to interfere too much with market valuation of currencies, though they do try and contain excessive volatility. Second, every time the RBI sells dollars, it buys up rupees, thus sucking some liquidity out of the system. Given the current liquidity crunch, that is obviously not something it would be very keen to do. Do we gain or lose when the rupee depreciates? The answer is less simple than it might seem. Exporters clearly gain when there is a depreciation, since they can price their goods cheaper in dollars and yet earn the same amount of rupees, making them more competitive internationally. However, importers lose because their costs go up and since they are likely to pass this on to consumers it means costs in the economy rise. In theory, as import costs rise, imports should fall and with exports rising the trade gap should close thereby correcting the demand-supply mismatch in dollars and leading to the rupee appreciating again. In practice, this often does not happen. One reason is that not all imports may be price elastic that is, some imports might not be reduced despite higher costs. The same may be true in exports, where some exports may not gain since their demand is not price elastic. Also, other factors including speculation may more than offset any reduction in the trade deficit. Hardwork is like Staircase & Luck is like Lift. Lift may fail sometime,but staircase will surely take you to the top  A S R Pratap |
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