Factors Determining Valuation of Currency

Currency came around several hundreds of years ago as a means to replace the barter system. Early currencies were “commodity money,” meaning they derived intrinsic value from the precious metals they were made of. However, its impracticality caused the shift towards “representative money” — money lacking intrinsic value but backed by its ability to be traded for a physical commodity. The most notable use of representative money is under the gold standard, where each country’s currency is tied to a fixed amount of gold. However, this too had its drawbacks and so after World War I and II, it was abandoned and our current form of money — fiat money — was introduced. Fiat money does not possess intrinsic value nor is it backed by commodities. Rather, its value is determined by supply and demand, backed by the creditworthiness of the issuing government.

Coming back to the present, these past few weeks have seen our Indian Rupee (a form of fiat money) cascading to new lows nearly every other day, making the headlines of every other news channel. Living under a rock wouldn’t give you the excuse of being unaware of such a crisis. The unstable currency has slipped the country into disarray. Since the beginning of this year, its value has been taking a hit due to global economic difficulties aggravated by the Covid-19 pandemic, inflation, supply chain disruptions, the Russia-Ukraine conflict, rise in the dollar’s value, and high crude oil prices, to name a few. Such events make you wonder how exactly it is that we are able to measure the rupee against other currencies of the world. But first we have to know what a currency’s value is affected by.

Factors Affecting Currency Value:

1. Interest Rates: Currencies of countries offering higher interest rates tend to increase in value, all else being equal. This is because fixed-income investors flock to higher interest rates, which increases the currency’s demand and value.
2. Inflation: High inflation erodes the purchasing power of the currency holder and increases the cost of local goods. Countries that experience higher inflation may experience a decrease in currency demand, and therefore a depreciation in currency value.
3. Capital Flow: Capital flow represents a large portion of the demand for currency. Large amounts of capital inflow going into a country appreciate the currency, while capital outflow depreciates the currency.
4. Money Supply: Money supply refers to the money within a country at a given point in time. The higher the money supply, the lower the currency value and vice versa.

Trend of Rupee against other Currencies:

On 17th August 2012, precisely a decade back, the rupee/dollar exchange rate was 55.63. As of 17th August 2022, it is 79.45. Clearly, the value of the rupee has fallen by over ₹20. But what exactly does this mean? The rupee’s exchange rate vis-à-vis the dollar is essentially the number of rupees one needs to buy $1. This is an important metric to buy not just US goods but also other goods and services (say crude oil) trade in which happens in US dollars.

The following graph shows the trend of the Indian Rupee against the U.S. Dollar:

We can clearly see a constant decrease in the value of the rupee as compared to the dollar. The upward slope indicates that 1 U.S. Dollar is worth more in terms of rupees and thus, the rupee can now buy you less in dollars.

The following graph shows the trend of the Indian Rupee against the British Pound (GBP):

The Indian Rupee has had a rocky path till now when we talk about the British Pound. It gradually declined in value from 2011 to 2014. Then, it suddenly rose till 2017 after which it regained its upward trend.

International Currency Exchange Rate:

On a fundamental level, currency value is determined by supply and demand, both domestic and foreign. International currency exchange rates display how much one currency unit values against another. Increased demand appreciates the currency value, while increased supply decreases the currency value. Knowing the value of a home currency with respect to different foreign currencies helps investors to analyze assets priced in foreign dollars. For example, an Indian investor, who wants to invest in the USA, would first study the rupee to U.S. Dollar exchange rate. Finding it valuable would encourage his ventures, and the opposite would strongly suggest against them.

What are Exchange Rates?

Fluctuations in the value of the rupee, as shown above, with respect to other currencies are part of everyday news. As we all know, the value of the rupee changes almost daily, just like any other currency. But why does it happen so? This concept of currency fluctuation is part of the larger Foreign exchange market, where trading one currency with another at a particular rate occurs. This is the most common way to measure currency value — by measuring its convertibility to other currencies — also known as the exchange rate. Since the end of the gold standard in 1971, the majority of the world’s currency has adopted one of two exchange rate systems. This rate is known as the exchange rate.

1. Floating Exchange Rate:

In most countries, their currency’s value is determined by floating exchange rates. For egs: the U.S. Dollar, British Pound. In this system, the value of a currency is determined by the basic economic concept of Demand and Supply. It is as simple as a currency with more demand will have a higher value. As the exchange of different currencies takes place in the Exchange market, the demand for each currency in the market determines its value. In this process of value determination, the government of a country exercises negligible control. Nevertheless, the government or the central bank of the respective country intervenes and takes preventive measures when the currency destabilises or performs poorly.

1. Fixed/Pegged Exchange Rate:

The second method is known as the fixed/pegged exchange system. In this approach, the government sets the fixed/pegged rate through the country’s central bank. They set the rate against another leading world currency (such as the U.S. dollar, euro, or yen). To maintain this exchange rate, the government will buy and sell the currency against the value of the currency to which it is pegged. For egs: the Hong Kong Dollar is fixed to the USD, the Nepal Rupee is fixed to the INR.

Factors Affecting Exchange Rates:

Many macro factors also affect exchange rates. The “Law of One Price” dictates that in a world of international trade, the price of a good in one country should equal the price in another. If prices get out of control, the interest rates in a country will shift or the exchange rate will change between currencies. However, reality isn’t always obedient to economic theory, and due to several mitigating factors, the law of one price does not often hold in practice.

Still, interest rates and relative prices will influence exchange rates to some extent. Other factors that affect foreign exchange rates include the political climate of a country, inflation, public debt, GDP, confidence, central bank/government intervention, and the balance of trade.

1. Political Stability — A politically stable country attracts more foreign investment, which helps prop up the currency rate. Contrarily, poor political stability devalues a country’s currency exchange rate. Political stability also affects local economic drivers and financial policies.
2. Inflation — Inflation is the relative purchasing power of a currency compared to other currencies. Inflation is the reason why different currencies have different purchasing powers and hence different currency rates. Thus, countries with low inflation typically have stronger currencies compared to those with higher inflation rates.
3. Public Debt — Most countries finance their budgets using large-scale deficit financing — they borrow to finance economic growth. If government debt outpaces economic growth, it can drive up inflation by deterring foreign investment from entering the country, devaluing a currency. In some cases, a government might print money to finance debt, which also drives up inflation.
4. Confidence — Currencies may be affected by the confidence traders have in a currency. Currency changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a currency based on an election outcome, especially if the result is perceived as unfavorable for trade or economic growth. In other cases, traders may be bullish on a currency because of economic news, which may buoy the currency, even if the economic news itself did not affect the currency fundamentals.
5. Government Intervention — Governments have a collection of tools at their disposal through which they can manipulate their local exchange rate. Central banks are known to adjust interest rates, buy foreign currency, influence local lending rates, print money, etc. to modulate currency exchange rates. The aim is to ensure favorable conditions for a stable currency exchange rate, cheaper credit, more jobs, and high economic growth.
6. Balance of Trade — Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. If a country has a positive balance of trade, it means that its exports exceed its imports. In such a case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters the local currency exchange rate.

In this article, we have read about the methods to compare various currencies from around the world with each other. These cause fluctuations in the currency, as we are seeing with the Indian Rupee. It is affected by a plethora of micro and macro, global and domestic factors. I would like to conclude this article by reminding you all that this is a very vast topic. I have not yet delved into the depths of this field but I certainly hope to.

BIBLIOGRAPHY:

• https://www.bookmyforex.com/blog/1-usd-inr-1947-till-now/
• https://corporatefinanceinstitute.com/resources/knowledge/economics/how-is-currency-valued/
• https://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp#:~:text=Currency%20prices%20can%20be%20determined,high%2C%20the%20value%20will%20increase.