Why does the rupee rise and fall? Key factors that move India's currency

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We have all heard about the rupee either appreciating or depreciating. But how does a currency fluctuate?
Globally, countries have their own currency, but from a trade standpoint, the US dollar plays a dominant role in many international transactions, especially in commodities like crude oil and gold.

The rupee operates under managed floating exchange rate, so the global macroeconomic factors and the domestic economic factors impact the currency value. However, it is regulated by the Reserve Bank of India (RBI) to prevent excess volatility. So, what are the factors that impact the rupee?

Dollar demand

The US dollar is the global reserve currency. When the demand for the US dollar increases, the rupee depreciates, and conversely, when the demand for the dollar falls, the rupee gains. Moreover, when there is global uncertainty, investors may become risk averse and prefer safe haven assets such as the US dollar.

Trade

Exports are another way to boost the foreign reserves, as the country receives the money after selling the goods and services, while imports reduce the foreign reserves as the country needs to pay for the goods and services. India is one of the major importers of crude oil and when the oil prices rise, the import bill increases, which makes the rupee weaker.

Inflation

Inflation refers to the gradual increase in prices in an economy over a period of time. This reduces the purchasing power of money. So, the value of the currency now will reduce in the future.

Moreover, high inflation will increase the input cost, which will make the exports less competitive. This is the reason the RBI tries to maintain a stable inflation rate. The RBI's inflation target is 4 per cent, with a lower tolerance level of 2 per cent and a higher tolerance level of 6 per cent.

Foreign exchange reserves

A higher foreign reserve acts as a buffer to provide the stability to the rupee. This is the reason why foreign institutional investors and foreign direct investment are encouraged as adequate foreign inflows provide a cushion against a negative shock and help the RBI manage volatility in the currency market.

However, FIIs are sensitive to global economic factors and the US interest rate. When the US interest rates rise, it becomes attractive for investors. When FIIs sell the stocks in the equity market, it impacts the rupee as there is outflow of foreign exchange.

A stronger rupee is good for imports as importers need to pay fewer rupees for goods and services priced in US dollars. Whereas a stronger rupee can make Indian exports less competitive in international markets.

For example, if the rupee is at 50 against the dollar and your import was worth USD 100, then the total amount you would pay is Rs 5,000. However, if the rupee is at Rs 100 against the dollar, the same import becomes expensive as you need to pay Rs 10,000 to purchase the goods or services.