Foreign Exchange Rate

Foreign Exchange Rate and Foreign Exchange Market

• Foreign exchange refers to any foreign currency; thus, for India, currencies such as US dollar and British pound constitute foreign exchange.

• Exchange rate is the price of one country’s currency expressed in terms of another country’s currency; for example, on 29 December 2011, 1 US dollar ≈ ₹52.7, implying that ₹52.7 was the exchange rate of the dollar in terms of the Indian rupee.

• Between October 2006 and December 2007, the Indian rupee experienced about 15% appreciation against the US dollar.

• After January 2008, the rupee began to depreciate due to capital outflows by Foreign Institutional Investors (FIIs) and fell to ₹49.44 per US dollar on 27 November 2008.

• From the second half of 2009–10 to August 2011, the rupee appreciated as capital flows returned to India, and its value improved to around ₹45 per US dollar by the end of August 2011.

• From September 2011, the Eurozone sovereign debt crisis triggered large FII capital outflows from India and other emerging economies, causing a sharp depreciation of the rupee, which fell to ₹54 per US dollar on 15 December 2011.

• Following this depreciation, the Reserve Bank of India (RBI) intervened by selling US dollars from its foreign exchange reserves in the foreign exchange market, helping to keep the rupee within the range of ₹52–₹53 per US dollar between 16 December 2011 and 13 January 2012.

• By 5 March 2013, the Indian rupee had depreciated against the currencies of almost all countries, with Japan being the exception; on that date, the exchange rate stood at ₹54.9 per US dollar.

• Since the exchange rate of the rupee is now market-determined, it has exhibited significant volatility, particularly during the period 2004–2011.

Floating (Flexible) and Fixed Exchange Rate System

• Since exchange rate is a price, its determination can be explained through the demand for and supply of currencies; in the case of India–USA transactions, the demand for and supply of US dollars represent the demand for and supply of foreign exchange from India’s perspective, while the price of a US dollar in terms of Indian rupees (or dollars per rupee) constitutes the exchange rate.

• Under a flexible (floating) exchange rate system, the value of a currency is allowed to adjust freely according to the demand for and supply of foreign exchange; hence, the exchange rate is market-determined and fluctuates with changes in demand and supply conditions.

• Under a fixed exchange rate system, the exchange rate is determined by the government rather than by market forces of demand and supply of foreign exchange; this system prevailed internationally under the Bretton Woods Agreement, reached in July 1944 at Bretton Woods, New Hampshire.

• In a fixed exchange rate system, the exchange rate is pegged at a specified level and is not allowed to be determined by demand and supply; therefore, if balance of payments disequilibrium creates either excess demand or excess supply of foreign exchange, the Central Bank must intervene by buying or selling the required quantities of foreign exchange to remove the imbalance and maintain the fixed rate.

• In 1977, the USA decided to float the dollar and adopted the flexible exchange rate system, a move that led to the collapse of the Bretton Woods fixed exchange rate system.

• Both flexible (floating) and fixed exchange rate systems possess their own advantages and disadvantages, and neither system is free from limitations.

Appreciation and Depreciation of Currencies

• Appreciation of a currency refers to an increase in its value relative to another foreign currency; for example, if the exchange rate changes from ₹45.50 per US dollar to ₹44 per US dollar, the Indian rupee appreciates, indicating a strengthening of the rupee.

• Appreciation of one currency implies depreciation of the other currency; therefore, when the Indian rupee appreciates against the US dollar, the dollar depreciates against the rupee.

• Depreciation of a currency refers to a fall in its value relative to a foreign currency; for example, if the exchange rate changes from ₹45.50 per US dollar to ₹46 per US dollar, the Indian rupee depreciates, indicating a weakening of the rupee.

• Under a flexible exchange rate system, the exchange value of a currency can frequently appreciate or depreciate in response to changes in the demand for and supply of that currency.

• Under a fixed exchange rate system, the government or central bank buys and sells foreign exchange to maintain the exchange rate at the officially controlled level; however, the value of the currency may still be altered occasionally through official decisions.

• A one-time official reduction in the value of a currency under a fixed exchange rate system is called devaluation; unlike depreciation, it is not a market-driven change but a deliberate policy action.

  • India devalued the rupee in June 1966 by lowering its value against the US dollar and U.K. pound sterling.

  • India again reduced the value of the rupee by about 20% in July 1991.

• Devaluation differs from depreciation because devaluation is an occasional official reduction in currency value under a fixed exchange rate system, whereas depreciation can occur frequently due to changes in demand and supply under a flexible exchange rate system.

• Under a fixed exchange rate system, a one-time official increase in the value of a currency relative to foreign currencies is called revaluation.

• Since March 1993, India has made the rupee convertible into foreign currencies and has allowed its value to adjust freely according to demand and supply forces, moving away from official exchange rate determination.