FOREX RESERVE AND RUPEE’S EXCHANGE RATE

Recently, there has been a fall in the rupee’s exchange rate (nearing 80 to a US Dollar), as well as a fall in the forex reserves. The relationship between the forex reserve and rupee exchange rate is:

• Exchange rate: It is the price of one currency in terms of another currency.
• Exchange rates can be either fixed or it can be floating.
• Fixed exchange rates are decided by the central banks of a country.
• Floating exchange rates are determined by the mechanism of market demand and supply.

Rupee’s exchange rate:

• In the beginning, for every rupee demanded in the market, there is a demand for a US dollar. The exchange rate between the two currencies would be one.

• But if over the period more dollars are demanded than the rupee, then the dollar would appreciate against the rupee.
• If this trend continues for a longer period, then the rupee will keep becoming weaker and weaker and its exchange rate will keep falling.

Impacts:

• Indian imports will become expensive as the rupee buys less and less of products sold in dollars. (India is heavily dependent upon the import of oil, nearly 85% is imported.)
• Not just oil but electronic items, such as mobile phones, some cars, and appliances, are likely to get expensive.

[The basket of Indian imports includes crude oil, coal, plastic material, chemicals, electronic goods, vegetable oil, fertilizer, machinery, gold, pearls, precious and semi-precious stones, and iron and steel]

• Education and travel in foreign countries will become expensive.
• Remittances: Non-Resident Indians (NRIs) who send money back home will end up sending more in the rupee value.
• In the case of fertilizer, the government subsidy bill is estimated to rise to Rs 2.5 lakh crore in this fiscal against Rs 1.62 lakh crore in the previous year due to the high prices of fertilizers in the global markets coupled with the rupee depreciation.
• Rise in import bills will also increase inflation in the country. Prices of imported intermediate goods will go up and that will push the manufacturing cost of businesses, who would pass that cost on to the consumers, which would push the price of goods.
• Indian exports to the US will increase, as the rupee’s depreciation makes India’s products cheaper and it will be more affordable to US customers.
• However, India’s current account deficit is expected to deteriorate in the current fiscal on account of costlier imports and poor merchandise exports.

Relationship between Forex Reserves & Exchange Rate:

• The rupee’s exchange rate will be changed based on the relative demand for the rupee among foreigners and the demand for the dollars among Indians.
• In case such relative demand fluctuates wildly, then, predictably, the rupee’s exchange rate too will fluctuate wildly.
• Sharp and repeated fluctuations will, however, destroy many firms.

When the RBI buys the dollars, they become India’s forex reserve.

This exchange reduces the presence of dollars and increases the presence of the rupee in the forex market, thus holding back the rupee from becoming stronger against the dollar.

One of the key reasons why RBI intervenes in the forex market is to smoothen the volatility of the exchange rate.