Currency prices fluctuate regularly and there are some fundamental factors behind this fluctuation. The primary basic thing that impacts the currency equation is the demand-supply.
When the demand for the rupee is getting higher the price of rupee will go higher when the demand for the rupee is going down, the dollar will become stronger. But what actually are those factors which impact the demand-supply equation?
Below are some factors which effects the demand supply of rupee dollar
1. Commodity prices impact on currency
India imports a lot of commodities; most of them are international commodities that are traded in dollar. So when the price of these commodities goes up and the domestic demand is same there will be increase in the demand for dollars. This increase in demand will make dollar strong and rupee weak.
Let’s say India needs 100 barrel of oil and the price of crude oil is 40$ a barrel, in that case the outflow will be
100x40 = 400$
But if the price of crude oil goes up to 60$ a barrel. India will have to spend 100x60 = 600$ , which means increase in the demand of dollar
That’s why the rise in the price of crude oil makes rupee weak and dollar strong.The same goes with Gold, whose largest importer in the world is India. Higher the price of Gold weaker will be the rupee.
To keep the price of rupee stable in the rising commodity price environment, we have to reduce the demand of those commodities which is not practically easy to do.
2. Liquidity impact on currency
RBI control the flow of money in the domestic market. This is done through various policy rates. Like CRR, SLR, Repo rate. How these rates impact the rupee dollar equation?
Cash reserve ratio tells how much money banks needs to keep in cash with themselves. Lets say this ratio is 10%, in that situtution 10% of the money that banks holds will be kept in the lockers of banks and it wont be flowing in the market. If RBI reduces this CRR rate to 5% a lot of extra cash will flow in the market. This extra flow means increased supply of rupee in the market. More supply of rupee means it’s going to go weak against those currencies whose supply is same like dollar, pound, yen.
The same way other ratio like SLR , Repo rate can impact the supply of rupee in the market. Tighter monetory policy will reduce the supply of rupee in the market and make it strong against other currencies while easing ratio will increase the supply of rupee and make it weak against other currencies.
3. Inflow out flow of foreign capital in India
Inflow and outflow of capital also impacts the demand supply of rupee in the market. When foreign money comes in India in the form of investment or remitence it increases the supply of foreign currency in India and relatively increases the demand of rupee, which has a positive impact on the strenght on Rupee.
Lets say Amazon comes to India and invest 10 billion dollars in India. As dollars are not used in India, Amazon will give this 10 billion dollar to RBI and will get equivalent amount of Rupee which will be approximately 700 billion rupees at the USDINR rate of 70.
That is why FDI/FII investment in India is positive for the rupee.
Similarly when there is outflow of Foreign capital from India, there is increase in the demand for dollar, as the foreigners sells their investment in ruppee, gives that rupee to RBI and takes the dollar in return. This results in increase of demand for dollar and increase of supply of rupee.
4.Credit rating impact of rupee
So these are the major fundamental factors which decides how the rupee is going to behave against the dollar.