Currencies always move in pairs. It is one currency against the other. Hence if one currency depreciates the other currency appreciates. What leads to the depreciation or appreciation of one currency against another currency? Market forces are the primary reason for currency appreciation or depreciation as currency demand and supply is predominantly speculative in nature. However market forces require a catalyst for buying or selling currencies and that catalyst is provided by policy makers of countries i.e. governments and central banks.
Take the example of the US Dollar and Indian Rupee or the USD/INR pair. The current rate of the USD/INR pair as of mid February 2012 is Rs 49.50. The pair had gone up to over Rs 54 in December 2011 from levels of Rs 44 seen in July 2011. What made the INR lose in value against the USD and then bounce back? One of the reasons for the sharp fall in the INR value against the USD was the global risk aversion due to worries of sovereign debt default by countries in Europe. The USD index, which is a trade weighted average of six foreign currencies against the USD, rose by 8% in a period of four months in late 2011 reflecting the risk aversion.
The policies of the Indian government and the RBI also played a role in the sharp depreciation and the subsequent appreciation from highs of the INR. India faced macro headwinds in 2011 in the form of high inflation and weakening government finances. Inflation was trending at over 9% levels for most of 2011 largely due to government policies of subsidies. The Indian government subsidizes food, fuel and fertilizer leading to artificial demand for these products, as pass through of price rise is not perfect. The government’s rising subsidy bill took up the country’s fiscal deficit over and above budgeted targets by 1%.
The RBI on its part had to fire fight rising inflation expectations and raise its policy rates sharply to bring down inflation expectations. The RBI made liquidity expensive for markets to allow for the pass through of the rate hikes into the system. RBI’s action of containing inflation expectations brought down India’s GDP growth from expected 9% levels to levels of 7% for 2011-12.
Currency markets did not view India’s rising inflation and falling growth levels positively. The fact that India’s economic woes coincided with global risk aversion drove down the INR against the USD. India’s economic woes to a large extent were driven by poor government policies.
The rise of the INR from lows of Rs 54 was prompted by RBI action. RBI curbed speculative trading of the currency forcing short sellers on the INR to cover positions. RBI also allowed banks to raise interest rates on USD deposits for Non Resident Indians. RBI made changes in its cancellation and rebooking of forward contract rules to prevent speculation by FII’s and exporters. RBI curbs on speculation helped the INR gain ground against the USD. However RBI’s actions are temporary in nature and will not determine the USD/INR course in the long run.
The INR was helped by falling inflation expectation with inflation coming off to 7.5% levels in December from over 9% levels seen in most of 2011. Markets took the sign of inflation coming off positively and lowered its negative outlook on the INR.
The reversal of global risk aversion also helped the INR as equity markets rallied across the globe on positive economic data and signs of control of the Eurozone debt crisis. FII’s flows into India turned positive with FII’s buying over USD 6 billion of equity and debt in the beginning months of 2012.
In the long term it will be the policies of the US and Indian governments and the policies of the US and Indian central banks that will determine the value of the pair.
