How is the value of rupee determined?
Rate of Retail inflation in India. The understanding of the inflation is the key to understanding the real effective interest rate. The REER is a barometer as to whether the currency is overvalued or undervalued. For example, if India Has an inflation rate of 6% and US inflation rate is 2% then the Indian rupee is expected to depreciate around each year by 4%. If it depreciates less than that the rupee will be overvalued and if it depreciates more than that then the rupee will be undervalued.
The real rate of interest in the economy. The understanding of the real rate of interest in the economy is an extension of the inflation concept. For example, if the 10-year G sec has a yield of 6.5% and if the inflation is at average of 2% then the real interest rate is 4.5%.
Normally there is a positive relationship between the real interest rates and the INR. That is why whenever the RBI hikes the interest rates the INR actually sees an appreciation in value because the higher interest rates would have increased the real rates of interest proportionately. Also when real interest rates are high we see more flows into debt from foreign portfolio investors. As more dollar flows in the additional supply of dollars in the markets tends to make the INR stronger.
Seasonal dollar demand from the importers and banks. Normally importers and foreign currency borrowers have seasonal dollar requirements for payouts to foreign parties. For borrowers there is the interest component on bonds and the redemption of these bonds when they become due.
In case of importers there are regular remittances that have to be made against the goods imported. Normally when the demand for dollars tends to get bunched together we see pressure on the INR and a weakening of the rupee. Normally the demand for dollars tends to shoot up when the currency markets become more volatile. At that time importers and banks tend to rush to hedge their positions and this demand tends to push up the forward premium and leads to a depreciation of the INR.
Trade related factors are more long term in nature. Economies that tend to see consistently elevated levels of trade deficit tend to have a weaker currency. India runs a monthly trade deficit of 12 billion dollars. Currently the annual import bill is around 420 billion dollars.
Kautilya, IBS Mumbai.