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How the value of a currency is determined

Amitabh Tiwari
·Columnist
·5-min read

By Amitabh Tiwari & K Shankar

The rupee (INR) has depreciated by 3.25% against the dollar (USD) during this calendar year. It was trading at 73.52 to a dollar today. So how are these currency values determined? What are the factors that impact the exchange rate? All this, and much more in this article.

The years 1944 and 1971 are very important in the development of currency exchange framework.

The Bretton Woods Agreement (BWA) was negotiated in July 1944 by delegates from 44 countries. It created a collective international currency exchange regime.

BWA required a currency peg to the US dollar, which was in turn pegged to the price of gold with diversions of only 1% allowed. These countries were brought together to help regulate and promote international trade across borders.

In 1971, following concerns that the United States’ gold supply was no longer adequate to cover the number of dollars in circulation, President Richard Nixon devalued the US dollar relative to gold.

By 1973 the Bretton Woods System had collapsed. Countries were free to choose any exchange arrangement for their currency, except pegging its value to the price of gold.

A currency value is dependent on:

Country’s economic prospects: This means higher the productivity/growth prospects, greater the visibility/institutional credibility and better the price stability, then stronger would be its currency.

Relative Demand for the currency in global markets: Like other products and commodities, currency is no different. More the demand for a currency compared to others, higher would it be its value.

This demand could be due to a variety of factors right from more tourists visiting the country and spending on local goods to foreign investors/MNCs investing in the country (strategic investment), to transactional (i.e. trade and remittances) to speculative/hedging purposes.

Fiscal and Monetary policy of the nation: Like tariffs on certain imported goods, trade pacts/treaties, differential pricing/payment of certain products with certain specified countries, apart from intervention by the nation’s central bank.

Global factors like monetary policies of the US Federal Reserve System, trade protectionism measures announced by various governments, geopolitics, managing currencies to aid exports also impact currency exchange rates.

Based on a country’s competitive strength and its economic prospects, the policymakers along with its central bank decide on whether to keep their currency - fully floating or partially floating or pegged.

Fully floating – the demand and supply of its currency in the foreign currency markets determines the exchange rates. There is no intervention by the central bank to guide the currency in a particular director nor arrest the rise or support the fall in its value. The US dollar, Euro is an example of this.

Partially floating: The demand-supply and economic developments determines the exchange rate, but the central bank monitors the rate closely and intervenes depending on its exchange rate philosophy. For example, India’s central bank, the Reserve Bank of India, periodically intervenes to ensure that the Rupee does not appreciate/depreciate significantly especially against the US dollar.

Pegged Rates: The central bank becomes a market maker of sorts in such situations by announcing the rate at which its currency will be bought or sold. The Hong Kong Dollar has been pegged to the US dollar since 1983.

Due to globalization and collapsing of trade barriers most of the countries have floating exchange rates and very limited countries still follow a pegged rate policy.

While conceptually, floating means global demand and supply determining the exchange rate, countries do follow/adopt different methods of monitoring its exchange rates.

“While currency can be pegged to a major world currency, usually US dollar, many currencies are floating, i.e., their value is determined by demand and supply forces. More the demand, from investors chasing onshore assets, higher local interest rates or diaspora repatriating funds, stronger will be the currency,” says FX trader of a MNC Bank in India who spoke on condition of anonymity.

He adds, “There are either free float currencies (completely determined by markets) like GBP/JPY/EUR against the US dollar, others are ‘managed’ floats, like INR, CNY where in addition to market forces, usually central bank controls the movement either through a pre-established daily band or intervening in whichever side that suits country’s policy stance.”

An import-dependent economy or industry is more affected by the exchange rate depreciation than a domestic resource dependent economy. India imports roughly 80% of its crude oil requirements while it is the largest importer of gold in the world. Depreciation of currency increases our import bill. Any adverse movements in prices of oil / gold also lead to imported inflation.

An export-dependent economy like China could suffer from appreciation of its currency, as it makes its exports less competitive. This is one of the primary reasons why it manages its currency.

World over the focus now is on the stability of the currency rather than just the value. Lower volatility in a market determined exchange rate reflects relative sovereign credit strength.

"The exchange rate, both in terms of its level and changes, serves a dual role of a rear view mirror and crystal ball. It is one of the key barometers of the nation's current and prospective economic and financial health, a reflection of global investor confidence over the nation's productive capacity as well as institutional and policy credibility, “says Sumedh Deorukhkar, Senior Economist, BBVA.

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Amitabh Tiwari is a former corporate and investment banker turned political commentator and strategist. He tweets @politicalbaaba.

K Shankar is a MBA in finance with over 2 decades of experience in equity research and financial analysis.