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First, the basics
Inflation is an increase in the price of a set of goods and services that is representative of the economy. Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money - a loss of real value in the internal medium of exchange and unit of account in the economy.
Exchange rate is the current market price for which one currency can be exchanged for another. If the U.S. dollar exchange rate for the Indian Rupee is Rs. 63, this means that one American Dollar can be exchanged for 63 Indian Rupees.
Relationship between rupee exchange rate and inflation
The common understanding of the relationship between rupee exchange rate and inflation is when the rupee vis-a-vis dollar (as dollar constitutes the major currency exchanged in the world) exchange rate falls inflation rises and vice versa.
Let us try to understand how this happens. We can take an example of fall in rupee value against the major currencies in the world, say, dollar from Rs 45/- a dollar to Rs 63/- a dollar in the last 24 months. What is the impact of this depreciation of rupee vis-a-vis dollar? The immediate impact is an import worth $ 1000 will now cost Rs 63,000/- instead Rs 45,000/-. As all of us are aware, almost 70 per cent of the petroleum products which is consumed in the country is imported as we only produce domestically 30 per cent of our requirement. Every citizen in this country feels the pinch of rising petroleum prices almost every two months by the government. The rise in price of this commodity alone has a cascading effect on all other commodities which we consume as all these commodities need to be transported to reach the consumers.
This was just one example. Another example is that of import of gold. India happens to be the second largest, after China, importer of gold. Gold, no doubt has historically been a buffer against inflation. But of late it has also become a cause for increasing inflation, for the simple reason is that gold is an unproductive asset and buying gold has resulted in current account deficit causing further fall in the value of rupee. A falling rupee makes all other imports costlier, thus fuelling inflation.
India also imports variety of other products and services from across the globe. The prices of all these products and services have risen because of rupee depreciation and thereby causing further rise in inflation.
Fall in value of rupee makes the exporters happy, because for the same value of goods in foreign currency they get more amount of Indian rupees. However, this excess rupee is not due to selling of more goods but fall in the value of rupee, that the additional funds are not backed by increased production, so we have more money in the economy, which further fuels inflation.
Impact of type of exchange rate systems on inflation
While we know now that exchange rates have a strong bearing on inflation, a lot also depends on the type of exchange rate that a country has opted for. Exchange rate systems are broadly divided in two categories:
(i) fixed exchange rate system, and
(ii) floating exchange rate system.
The fixed exchange rate system is divided into (i) crawling peg system and (ii) currency board system. The floating exchange rate system is again divided into (i) independent floating system and (ii) managed floating system.
In fixed exchange system a country pegs i.e. attaches its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners; and the weights given to the different currencies reflect the distribution of trade, services, or capital flows of the partner countries. In crawling peg of exchange system the currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators.
Currency board system is one in which the monetary authority makes decisions about the valuation of a nation's currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves. The currency board then allows for the unlimited exchange of the local, pegged currency for the foreign currency. A currency board can only earn the interest that is gained on the foreign reserves themselves, so those rates tend to mimic the prevailing rates in the foreign currency. India had been following a mix of both systems till 1991.
The volatility in exchange rate is less in fixed exchange rate system. Also as the exchange rates are fixed, depreciation of the domestic currency is not driven by market forces. It only happens when the government decides to depreciate the value as it happened for the first time in 1966, when value of dollar was hiked from Rs 4.30 to Rs 7.50. This resulted in a runaway inflation, which the government tried to control, but with limited success. Another example was in early 1972, when rupee was depreciated further resulting in very high inflation. Since 1991, India had been moving towards market driven exchange rate system.
In free floating exchange rate systems the exchange rate of a currency change relatively free flowing and is determined by market forces of demand and supply.
In independent free floating system the exchange rate varies without any intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate.
In managed floating exchange system the monetary authority attempts to influence the exchange rate without having a specific exchange rate target. In India, presently managed floating rate system is in vogue.
Volatility in inflation is usually higher in independent free floating system if the balance of trade is adverse which results in current account deficit, which then results in fall in the value of the domestic currency, resulting in inflation.
In managed floating exchange rate system, the volatility is checked by the central bank (Reserve Bank of India) with its intervention by buying or selling dollars from time to time.
The June - Sep 2013 rupee depreciation
The most recent event that is still fresh in most memories is the 20% depreciation that the rupee saw versus the US dollar in the June-Sep 2013 period. The immediate provocation for the slide is widely seen as the May 2013 statement of the US Fed Governor, Ben Bernanke, when he discussed the possibility of tapering down the US QE program which has flooded world financial markets with unprecedented liquidity. There are however, systemic pressures domestically that contributed to the magnitude of the fall.
The decline in rupee value, the Finance Minister pointed out, was mainly on account of supply-demand imbalance in the domestic foreign exchange market. "This is due to widening trade and current account deficits and slowdown in portfolio flows on account of escalation in euro crisis and strengthening of the dollar in the international market," he said.
The government has been maintaining that even as it has taken a number of fiscal and administrative measures to contain the price spiral, it was the rupee depreciation that had been contributing to inflationary pressures. "The decline in the exchange rate value of the rupee makes imports expensive. In situations where the higher cost is passed on to the consumers, it would contribute to inflationary pressures and general price rise," Finance Minister P. Chidambaram has told the Lok Sabha in a written reply.
This is the most recent example of the impact of rupee depreciation on inflation in the country.
Steps taken by RBI to stem the rupee slide and reduce inflation
To stem the rupee slide, the government and the Reserve Bank of India (RBI) had taken a number of steps to facilitate capital inflows, boost exports and, thereby, augment the supply of foreign exchange into the country. Among the steps taken were a hike in the FII investment limit in debt securities, a higher interest rate ceiling for foreign currency NRI deposits and deregulation of interest rates on rupee-denominated NRI deposits.
History of Exchange Rate and Rate of Inflation in India
At the time of our Independence, 1 US dollar was exchanged for 1 Indian rupee. Today, 66 years after Independence, 1 US dollar fetches over Rs.60. The journey of the Indian rupee since 1957 is shown below. You will see from the chart below how the country's exchange rate behaved during the days of fixed exchange rates and since 1991, its behaviour under a managed float system.
The history of inflation is similar to that of exchange rate. As exchange rate has been falling on a continual basis, so has been the rise in inflation. However, as fall in exchange rate is not the only reason for inflation, therefore, there were periods when inflation has not increased as much as in the fall in the value of rupee.
Chart - historic CPI inflation India (yearly basis)
How does inflation influence exchange rates?
So far we have discussed the impact of exchange rate on inflation. Let us now see the reverse, how does inflation influence exchange rates. Inflation does have a direct impact on foreign exchange rates, but the question is, "Is the relationship direct as claimed? Sometimes the two do have an inverse relationship while other times the relation is actually direct. Let us see how it happens.
Inflation affects the exchange rates in both ways. (i) It strengthens a currency. The first thing inflation does is make a currency stronger. This is because, if inflation is high, it encourages a central bank to raise interest rates. And higher interest rates make a currency more attractive. (ii) It weakens a currency. Secondly, high inflation weakens a currency too. This is because, if inflation is high, people have less money to spend. And less spending brings a currency down. In short then, inflation has a dual effect on exchange rates, because it affects the economy in both ways.
We give below a chart which depicts the inflation differential between two countries, India and US. As we see from the chart, compared to India, US always had a lower rate of inflation, which has one of the factors for strengthening the US currency vis-a-vis the Indian currency along with other factors. Economic theory suggests that inflation differentials between two countries contribute directly to currency depreciation in the country experiencing higher inflation.
Lets take a simple example to understand this better. Lets say that 1 year ago, the exchange rate was 1 US dollar = Rs. 50. Lets say, a year ago, sugar or onions (or any freely tradable commodity) was priced at 1 US dollar per kg in USA and Rs.50 per kg in India.
Now, because of high inflation in India, lets say this commodity's price in India shoots up to Rs. 100 per kg, while its price in US remains at US dollar 1 per kg and the exchange rate remains the same at 1 US dollar = Rs. 50. Most smart global traders will spot a great arbitrage opportunity in buying the commodity in US and selling it in India. This arbitrage will create higher import pressure in India, thus fuelling demand for more dollars and thus weakening the currency. This should logically continue until the increased supplies from US cause the price locally to come down and the Indian currency to depreciate to an extent where the arbitrage is no longer viable. Thus, we see that inflation differentials contribute to currency movements.
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