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What finally drives exchange rates?
The rupee's movement against the dollar has profound implications for asset classes across equity, debt and precious metals. Financial advisors in India have increasingly realized the importance of tracking this important variable. And yet, this is one phenomenon that many of us struggle with in terms of understanding the underlying factors that determine its movements. For example, with equity, we have learnt that at the core is earnings growth - ultimately, equity markets reflect earnings and earnings growth - all the rest is temporary noise that causes markets to fluctuate around its fair value. With bonds, we know that interest rates are closely tied to underlying inflation in the economy. What then is that one factor that determines exchange rate of a country's currency?
Various experts talk of various factors at various points of time. Current account deficit, we are told, critically influences exchange rates. Extent of public debt (in other words fiscal deficit) is also cited by experts as a critical influencer. Economists will tell us that its all about inflation differentials between two countries, while some others tell us that interest rate differentials is what determines whether one currency appreciates against another or depreciates. We have also observed that economic prospects of a country influence FII inflows, which in turn impacts the currency. In other words, capital flows impact currency movements. So what finally is the underlying factor that influences exchange rates?
Its all about demand and supply
Every one of the factors we discussed above does impact the exchange rate. And there is in fact an underlying common factor that ties all of them together. And, that is the simple law of demand and supply. One of the first things we learn in economics is how changes in demand and supply impact prices of goods. When demand for a product, say cement, increases, producers increase the price. If the buyers continue to demand cement at a higher price (maybe because they are confident of passing on the increase through higher property prices to buyers of flats), producers consider further price hikes. This cycle reaches a point where either the buyers resist further purchases due to high prices or fresh supply comes in from new factories that producers set up, lured by super profits of the recent past. The producers of this new supply will be keen to sell at least break even quantities, and will therefore be happy to lower the price in order to ensure this. This causes prices to start falling.
Lets look at the other side of the cycle. If demand for cement is weak, producers will be keen to push some sales to minimize losses and will therefore cut prices to spur demand. They can keep cutting prices at least until break even levels, to ensure that factories continue operating. If demand continues to remain weak, prices will fall further and the more inefficient producers will go out of business, leaving only the most efficient producers in business. This contracts supply considerably, to a level below current demand - which then allows prices to stabilize and sets the tone for the next upcycle.
Law of demand and supply - applied to forex markets
This basic relationship between quantity (demand/supply) and price is one of the fundamental economic laws. The same law is what also determines exchange rates. To understand this better, lets treat the US dollar as a commodity - just as we took cement as an example above. When demand for US dollars in India exceeds supply of dollars in India, Indians have to pay a higher price for the US dollar to acquire it. Conversely, if India generates a lot more US dollars than it demands, we have a surplus of US dollars and the price we need to pay for US dollars falls as a consequence.
CAD as a driver - explained through demand and supply
Now, let's apply this insight in all the drivers of exchange rates that experts talk about. Let's take current account deficit first. Current account deficit (CAD) occurs when a country's exports fall short of imports - which means its earnings in foreign currency falls short of its spending in foreign currency. There is more demand for foreign currency (dollars) than supply - which means that the price of dollars goes up. In other words, we pay more rupees for the same dollar now, than earlier. Our rupee therefore depreciates against the dollar.
In this demand-supply situation, let's superimpose capital flows. Even if we are running a current account deficit, another source of supply of dollars that can make good the deficit is FII and FDI inflows into the country. This could be because foreign investors are enthused about the longer term prospects of the economy and believe that its worth investing their dollars here. When you have dollars coming in for investments, a fresh source of supply of dollars comes in, which helps plug the gap between the dollars we earn (exports) and the dollars we spend (imports). If FII and FDI inflows are substantially larger than the CAD, you can actually find the rupee appreciating rather than depreciating. Its all about demand and supply of dollars.
Of course, in this free market version, in reality, there is a market maker who steps in, in the form of the Central Bank (RBI) of a country. In order to minimize volatility in the exchange rates, RBI steps in to either buy or sell the dollar, when there is too sharp a mismatch between demand and supply - just as a market maker does in stock markets. This allows for the market to find its level, but in an orderly manner, without too much of fluctuations. Ultimately, the Central Banker can only smoothen the flow, but can rarely change the direction of movement.
Fiscal deficit as a driver - explained through demand and supply
The relationship between fiscal deficit and exchange rates is not such a direct one as that of CAD. When a country lives beyond its means (expenses in excess of receipts), it has a fiscal deficit that needs to be funded. We in India are quite familiar with this situation. This public debt could be either funded through domestic borrowings (Government borrowing program, small savings schemes etc) or external borrowings. To the extent that public debt is funded out of domestic borrowings, the link between fiscal deficit and currency is not a strong and direct one. However, for countries that depend on external borrowings, the link is very strong and direct. Its possible in such cases that a country does not have a serious CAD problem but has a big fiscal deficit that is funded by external borrowings. Here again, it is demand and supply for foreign currency that determines the exchange rate. So, as we can see, its not always that case that CAD drives currency movements, its not always the case that fiscal deficit drives currency movements - what is common in all cases is that the demand - supply equilibrium gets disturbed, which causes the price of the foreign currency to get reset, to get a new equilibrium.
Inflation as a driver
The link between inflation and exchange rates has been discussed in detail in an earlier Jargon Buster article (Click Here). While the cause-and-effect relationship has been discussed with examples in that article, suffice to say here that even in this case, what finally drives currency movements is that there is a larger demand for one currency to take advantage of an arbitrage opportunity that opens up, and this change in the demand and supply equilibrium causes currencies to adjust - in other words, causes prices to change.
To conclude
For financial advisors, the key insight worth keeping in mind is that if you would like to track currency movements, you need to think in terms of dollars as a commodity and track demand and supply in India of this commodity. When you see demand in India for dollars going up, and supply falling short, expect the price of dollars to increase - in other words, expect our rupee to depreciate. When you find supply of dollars increasing ahead of demand, expect the price of dollars to fall - in other words, expect our rupee to appreciate.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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