Jyotiprakash Pal
Sergeant
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If your country's currency is high in demand as compared to its supply, its value will increase But the key here is to understand the factors that affect this demand and supply because that is what determines its value, and that is what shapes our policies, and that is what we are going to break down for you in this video. Now there are five basic factors that affect the value of a nation's currency. Let's go through all of them one by one. Factor one inflation differentials The first reason, which is usually the textbook reason for fluctuation in currencies, is the inflation differential. That means you can buy more with one unit of currency. This means your purchasing power is higher. And what does higher purchasing power mean? It simply means the currency has more value. On the contrary, when a country's inflation rate is higher, it means items are more expensive so you can buy less of the product with the same amount of money. For example, suppose last year you could buy one liter of milk for ₹20, but this year you will just have to shell out ₹25 to buy the same one liter of milk. Due to high inflation rate, the value of the rupee has dropped. You need more money to buy the same amount of stuff. Factor number two interest rates. The second factor is interest rates, which is why everybody is so focused on RBI and US fed interest rate hikes. Central banks can influence exchange rates by changing interest rates. So how does this work? In simple terms it's this suppose you have a dollar deposit. Is the interest rate on it higher than a rupee deposit. Because if yes, then lenders would rather deposit dollars since they will get higher returns. So higher interest rates attract more foreign capital, which gives your currency a higher value since its demand is more. Now let me give you an example to explain this as well. Suppose interest rates in both US and India are 5%, but then the US fed hikes interest rates to 10%. What will happen? Well, foreign investors will withdraw rupees from Indian banks and convert it into dollars to deposit it into US banks since they are getting more returns. So demand for dollar rises, demand for rupee dips. And as we discussed, when demand for a currency increases, its value rises Factor number three political and economic stability. Just like us, the market craves stability and a strong, stable economy encourages investment, increasing the demand for the country's currency. When countries go through political or economic upheavals, it discourages foreign investment, reducing the country's currency's value. A case in point is the Sri Lankan rupee. The Sri Lankan rupee was down by a whopping 40% during the recent turmoil in the country. In fact, this is also why the dollar is so strong right now. It's considered to be a safe haven in these risky times with the pandemic, the Ukraine war and the likes. Factor number four the current account deficit. What does a deficit on the current account mean? It means that the value of the goods and services the country is importing is higher than the value they are exporting, hence the deficit. Now this deficit needs to be plugged through dollars. And how do we get dollars through investments that get recorded on the capital of financial accounts? However, a country that struggles to attract enough capital inflows to finance this deficit, currency will depreciate. Now, this is because the country is spending more on foreign goods and services, so they require more foreign currency. Remember, demand and supply, more demand for foreign currency and less for domestic will mean the country's domestic currency would dip. Factor number five. Public debt countries normally engage in large-scale deficit financing to pay for public sector projects, like the Indian government borrows money in order to finance certain schemes like they did during times of Covid. This is fine, of course, because it leads to domestic development. But suppose a country has taken too much money, then repaying that money would erode the country's forex reserves This means that it will be harder for the central bank to be able to smoothen fluctuations in the currency's exchange rate. How do forex reserves impact the central bank's ability to keep their country's currency stable, though? I'll get to that in just a minute. Also, foreign investors would also be less willing to own securities of a currency that has a greater risk of default. Hence, a country's debt rating is an important factor in determining its exchange rate. Now, central banks are the first line of defense to maintain the stability of a country's currency. So what can central banks like the RBI do to try and protect their domestic interests In the face of global factors? They can manage the value of the currency by controlling its supply in the market. Of course, this can be done to a certain extent. So here's what the banks can do. Central banks can buy or sell foreign currencies to buffer against external shocks. By doing this, they can maintain the price of the currency like the RBI has been selling dollars to try and keep the rupee value on an even keel since the prices of oil started rising. And this is why the RBI needs forex reserves. If they have less reserves, how will they sell dollars to provide a buffer? Central banks can of course adjust interest rates. We have seen how the RBI has just increased repo rates once again and as we discussed at the start of the video, high interest rates attract foreign capital and give the rupee more value. Central banks can also change the quantity of money available in the system by adjusting the cash reserve ratio, or CRR. This is the proportion of money that banks have at their disposal to lend because of course, money is more in demand when the supply is less. However, intervening in the forex market on a sustained basis has its own set of challenges. So while the central bank can help cushion the shock, it can't protect the currency against external factors for too long a period of time without affecting other important factors. For example, while policy rate hikes by central banks may attract foreign lenders, it pinches domestic consumers like the RBI. Increasing the repo rate means your home loans get more expensive. Higher interest rates mean that people borrow less, they spend less, and this helps the central banks bring prices down by adjusting demand and supply. This is how it controls inflation.
