These days headlines like “Rupee touches new high” or “Dollar takes a beating as rupee gets stronger” or “India’s Foreign Exchange reserve reaches all time high” very often occupy the premium position in newspaper pages. The latest in the series is that rupee has breached the Rs 40-a-dollar level to close at Rs 39.88. Most readers who do not understand the intricacies of currency pricing must be wondering what is going on? Has India become so rich that the mighty dollar, the symbol of global capitalism, is begging to retain its value against rupee?

Let us try and demystify why the value of rupee is rising so rapidly. Through this article we will cut the clutter and explain how a change in the value of rupee affects common man, like you and me.

The value of rupee
The rise in the value of rupee against dollar (that is amount of rupee required to buy one dollar) started in March 2002 when rupee had touched its lowest Rs 48.74. Since then rupee has been rising and rise became faster since the beginning of 2007. (See chart)

This is unprecedented because in the last 20 years or so, rupee has always been declining against dollar.
But how is the value of currency determined? Why is rupee valued at Rs 39.88 to a dollar and not Rs 20 or Rs 80? Well like all products and services the value of rupee also depends on the forces of demand and supply. Surely, the foreign funds who invest in our stock markets and foreign investors who are setting up businesses here bring large amount of dollars. And as more dollar flows in, higher is the price of rupee due to demand push. The NRIs who send in billions of dollars from abroad also contribute to this.

Currency pricing
Large dollar inflow leading to greater demand for rupee, is one of the many reasons. The value of a currency is always relative to another currency of another country against which it is benchmarked. For India, the intermediary currency for all our foreign trade is US dollar and hence the international price of rupee is always described against US dollar. True that we do have exchange rates against Sterling Pound, Euro and Yen, but rupee’s price against them is determined through their respective prices against dollar.

The rupee-dollar exchange rate is determined on the basis of the strength of both currencies, which in turn depends on a whole lot of factors like rate of inflation, rate of interest, export performance, import dependence and inflow of foreign investments. The low rate of inflation in the last one-and-half years, for example, has made rupee stronger.

The interest rate differential - despite several downward revisions our average interest rate at around 8 per cent is far higher than 3 or 4 per cent in the USA, is another force chasing rupee. Add to it low currency risk (that is lower possibility of rupee value going down) creating tremendous comfort levels for foreign investors.

Control factor
World currencies not always play by the market forces. In the developed economies like USA, countries in the Europe and Japan currencies are fully convertible with each other and their prices are determined by market forces. The other extreme case is the Fixed (or pegged) exchange rate, where the government of a country fixes an exchange rate and does not allow it to change for years, no matter what the real strength of the currency is. China, Hong Kong, Malayasia are the major countries having fixed-exchange rate. While the fixed rate has its own advantages in increasing exports and attracting foreign investments, it can be potentially dangerous if the poor fundamentals of the economy go out of hands. In India what we follow is a limited control through market intervention. The Reserve Bank of India (RBI), our central bank, often buys dollar from the market whenever rupee tends to go up fast. When RBI mops up dollar its demand and price go up resulting in rupee price become weaker in comparison to dollar. This is another reasons why our foreign exchange reserve has doubled to $220 billion in less than two years.

Direct impact
Whatever be the valuation mechanism, how does it matter to common man what a dollar is worth in rupee?
Like it or not, it does matter a lot because price of rupee affects imports as well as exports and that in turn determine prices of a host of our daily-use products. For example, when rupee goes up, imports become cheaper. No wonder the government is holding on to the price of petrol and diesel, which are mostly imported, though the international oil prices have shot up $80 a barrel. Unchanged oil prices, on the other hand, help keep the overall inflation low. 

Similarly, the fertiliser prices are frozen as India imports huge quantity of it. This will lower farmers’ cost of production and prices of food grains and cash crops, benefiting consumers. Then there are a whole lot of imported components for electronic and electrical goods and finished products (like mobile phones, TVs, music systems etc) that have become cheaper due to lower cost. Lower import prices force domestic manufacturers to keep their products competitively priced. The shirt that we wear, for example, uses polyester yarn produced from petrochemical whose price is closely linked with the international market and exchange rate. Conversely, when the value of rupee goes down, imports become more expensive forcing consumers to bear the burden.

Exporters’ woes
The other side of the coin is that people working abroad and those who are in export business get affected exactly in opposite manner. When rupee appreciates your earnings abroad in rupee term come down. Exporters earn less for every unit of item they export and they tend to become un-competitive in the highly competitive global market. No wonder the entire exporting community, including IT companies who earn in dollars, are seeking sops from the government. It is a matter of debate if our exporters need help but the hugely profitable IT companies certainly do not need pampering. 

Indirect impact
In an increasingly freer, global economy lower the control on a country’s currency price higher is the integration of the economy with the international market. This means that it is not only the economic factors of our own economy but that of our strong trade partners will affect our present and future. If the price of rupee goes weak and keeps falling, foreign investors will shy away from investment because their return in dollar terms will be lower in the future. Investors in capital market instruments (like shares and bonds) will pull their money out, lowering our forex reserve and weakening our import capabilities.

Similarly, the economic condition in the USA also has a lot to do with the rupee price. Last week when the US Federal Reserve lowered the interest rate the rupee became stronger, because international funds moved money from USA to India. The disturbing news from USA like subprime crisis, its huge current account deficit (it imports much more than exports), demand recession, etc, have all contributed to weaker dollar.

The mighty greenback is losing its value faster against important currencies like Pound Sterling, Euro and Japanese Yen. Experts believe that the dollar will weaken further and rupee may touch Rs 35 in another 12 months. Clearly, as the economy is booming, we will have to live with the rising rupee for months to come.