Group 9- Section C2

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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1.Introduction
This study aims to explore the dynamics, factors influencing and effects of
fluctuations in the exchange rate of Indian Rupee. Exchange rates play a vital role
in a country's level of trade, which is critical to almost every free market economy
in the world. Therefore, exchange rates are among the most monitored, analyzed
and governmentally manipulated economic measures. Exchange rate matters on a
smaller scale as well: it impacts the real return of an investor's portfolio,
profitability of firms, growth of specific sectors amongst various other
determinants of the economy.

2. Review of Literature and Earlier Studies

In the international finance literature, various theoretical models are available to
analyze exchange rate determination and behavior. Most of the studies on
exchange rate models prior to the 1970s were based on the fixed price
assumption1. With the advent of the floating exchange rate regime amongst major
industrialized countries in the early 1970s, an important advance was made with
the development of the monetary approach to exchange rate determination.
With liberalization and development of foreign exchange and assets markets,
variables such as capital flows, volatility in capital flows and forward premium
have also became important in determining exchange rates. Furthermore, with the
growing development of foreign exchange markets and a rise in the trading
volume in these markets, the micro level dynamics in foreign exchange markets
increasingly became important in determining exchange rates. Agents in the
foreign exchange market have access to private information about fundamentals
or liquidity, which is reflected in the buying/selling transactions they undertake,
that are termed as order flows (Medeiros, 2005; Bjonnes and Rime, 2003).
Microstructure theory evolved in order to capture the micro level dynamics in the
foreign exchange market (Evans and Lyons, 2001, 2005, 2007). Another variable
that is important in determining exchange rates is central bank intervention in the
foreign exchange market.
Exchange rate has fluctuated a lot from 1990-91, though fluctuations lie outside
the range of stability only for four out of 18 years of the study period. Indian rupee
in the terminal year has depreciated by nearly two thirds of its value in the base
year. Fall in the value of rupee has induced exports to rise ahead of income. The
export earnings in current exchange rate, absolute as well average, significantly
differ from earnings in the base year rate. But average import bills in two rates do
not differ significantly. Imports have not been significantly affected by depreciating
value of rupee, indicating positively sloped demand curve for imports. Results of
decomposition model of export earnings and import bills show the pivotal role of
change in exchange rate, though the quantitative dimension is relatively more
important in imports than exports.
Factors affecting the fluctuations in exchange rate of the Indian Rupee

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http://www.iioa.org/pdf/17th
%20Conf/Papers/4743149_090505_155551_INPUT_OUTPUT_MODELING_OF_IMPACT
_OF_EXCHANGE_RATE_FLUCTUATIONS_ON_INDIAN_ECONOMY.[1].PDF
The normality tests on the daily exchange rate returns for the last one-decade or
so indicate the need to explore the application of non-linear modeling techniques
while understanding exchange rate behavior. But we come to see that the results
from the persistence tests are split. The Variance Ratio results show that in the 3,
6 months and 2 years lag, the ratio has been greater than 1 that indicates the
persistence or a trend reinforcing tendency in exchange rate returns. However, the
3 months period shows a very close case of Random Walk. In the lag periods of 15
days, 30 days, 1 year and 5
Years the same is between 0 to 1 indicating mean reversion tendency or antipersistent. However, the R/S analysis does give indications of long-term memory
but with noise. In either case, analysis shows that the movement of exchange rate
does not follow a random movement. However, a more rigid analysis needs to be
performed, maybe by using Los modified R/S Analysis. Also, for a foolproof
analysis, the data used should be for a period longer than just one decade.
http://golak.tripod.com/icfai_ex_rate.pdf

3. Need/Importance of The Study

Exchange rate affects trading relationships between two nations. The
exchange rate of the currency determines the real return of the portfolio that holds
the bulk of its investment. The exchange rate influences purchasing power of
income and capital gains derived from returns, income factors such as interest
rates, inflation and even capital gains from domestic securities. The movements of
exchange rates also influence FDI through relative wage channels, relative wealth
channels, and imperfect capital market arguments.
The exchange rate is a very important monetary policy tool for emerging
economies like India. India has adopted inflation targeting and has less flexible
exchange rate arrangements. It intervenes quite frequently in the foreign
exchange market than their advanced economy counterparts. The enhanced role
of the exchange rate reflects these economies' greater vulnerability to exchange
rate shocks and their less developed financial markets. However, their sharper
focus on the exchange rate may cause some confusion about the commitment of
their central banks to achieve the inflation target and may also complicate policy
implementation. Global inflation pressures, greater exchange rate volatility, and
the financial stresses from the global financial turmoil that began in mid-2007 are
heightening these tensions.

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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4.Statement of The Problem

The persistent decline in rupee is a cause of concern. Depreciation leads to
imports becoming costlier which is a worry for India as it meets most of its oil
demand via imports. Apart from oil, prices of other imported commodities like
metals, gold etc will also rise pushing overall inflation higher. Even if prices of
global oil and commodities decline, the Indian consumers might not benefit as
depreciation will negate the impact. The depreciating rupee will add further
pressure on the overall domestic inflation and since India is structurally an import
intensive country, as reflected in the high and persistent current account deficits
month after month, the domestic costs will rise on account of rupee depreciation.
Exchange rate risk also drives away foreign investors which in turn depreciates the
local currency. Indian Rupee is currently caught in this vicious cycle; it will have to
find a stable level to regain investors confidence. The depreciating rupee has
serious effects on the external debt figures of the nation. The total external debt
has increased by Rs. 2186.8 billion to Rs 16384.9 billion by the end of November
2011.
Exchange rate affects trading relationships between two nations. Some of the
principal factors that cause fluctuations in exchange rate between two countries
are inflation, interest rates, current account deficits, public debt, trading terms,
political stability and economic performance. Lower inflation leads to a rising
currency value and higher inflation sees depreciation of currency. Higher interest
rates attract foreign capital and cause the exchange rate to rise and lower interest
rates decrease exchange rates. Current account deficit shows the country is
spending more on foreign trade than it is earning and there is an excess demand
for foreign currency which lowers the countrys exchange rate. A large public debt
encourages inflation which in turn will affect exchange rate. Increasing terms of
trade i.e. the price of a countrys exports rises by a greater rate than its imports,
increases the currencys value. Political instability and weak economic
performance cause loss of confidence in a currency and hence its devaluation.
Exchange rate graph (1963-2013)

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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5. Objectives
This is conceptual study based on Rupee Dollar relationship in terms of Rupee
appreciation that is dollar depreciation and rupee depreciation that is dollar
appreciation. It provides valuable insights into impact of changes in currency
relations on various sectors of economy keeping in focus economy in general and
Indian economy in particular. Pros and Cons of currency appreciation and
depreciation are studied as boon and bane for the economic growth. It also provides
suggestions or steps needed to control as well as to overcome ill-effects of
excessive fluctuations between rupee and dollar keeping in view current trends.
http://zenithresearch.org.in/images/stories/pdf/2012/March/ZIJBEMR/22_ZIJBEMR_MA
RCH12_VOL2_ISSUE3.pdf

5. Hypotheses
There are several factors affecting the exchange rate like the inflation, interest
rates, current account deficits, public debt, terms of trade, economic and political
factors FDI, FII, etc. From these factors we have identified three independent
variables:
1) Interest Rates
2) Inflation
3) Current Account Deficit
So, we have constructed following 3 Null hypotheses:
1st Ho : Interest rates do not have any effect on the exchange rate of Indian Rupee

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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2nd Ho : Inflation rates do not have any effect on the exchange rate of Indian Rupee
3rd Ho : Current Account Deficit does not have any effect on the exchange rate of
Indian Rupee
The corresponding Alternate Hypothesis are illustrated below ( We have used prior
knowledge to devise the alternate hypothesis in a manner which reflects the real
world scenario to be tested) :
1st H1 : Rise in interest rates would increase the value of the Rupee with respect to
other currencies.
2nd H1 : Higher inflation will lower the Rupee value.
3rd H1 : Higher the current account deficit, lower the Rupee value.

6. Research Methodology
Yearly data for the 3 Independent variables mentioned in previous section was
considered for the period 1991 -2011. Also data for the dependant variable Rupee
Exchange Rate with Dollar was considered for the same period (Source:
http://www.indiastat.com)
We performed Regression analysis on this data to observe correlation of the
dependant variable with the independent variables. Contribution of each
independent variable individually and their collective impact on the dependant
variable was observed.
Below are the values we have used for the analysis of the problem :

Year

Exchange rate US
Dollar

Inflation
rate

Interest
Rates

1990

17.4992

16.5

1991

22.689

13.9

17.875

1992

25.9206

11.8

18.916666
67

1993

31.4439

6.4

16.25

1994

31.3742

10.2

14.75

CAD
3.3279
7
2.2106
5
2.2668
8
3.8370
8
2.3625
1

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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1995

32.4198

10.2

1996

35.428

15.458333
33
15.958333
33

1997

36.3195

7.2

13.833333
33

1998

41.2665

13.2

13.541666
67

1999

43.0552

4.7

12.541666
67

2000

44.9401

12.291666
67

2001

47.1857

3.7

12.083333
33

2002

48.5993

4.4

11.916666
67

2003

46.5818

3.8

11.458333
33

2004

45.3165

3.8

10.916666
67

2005

44.1

4.2

10.75

2006

45.307

6.1

11.1875

2007

41.3485

6.4

13.020833
33

2008

43.5049

8.4

13.3125

2009

48.4049

10.9

12.1875

2010

45.7262

12

8.33335

2011

46.6723

8.9

10.166666
67

2.1431
1.9839
2.7421
9
3.2459
6
3.2420
3
3.7597
5
4.2867
9
4.5915
6
3.3752
1
3.2000
4
3.1778
8
2.2429
0.4706
2
4.8702
1
5.4187
3.6432
3.6821
5

7. Results & Discussion

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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9.

Findings
Correlation coefficient R of 0.89 clearly explains the relationship between the
actual values of three independent variables of inflation, interest rates, current
account deficit and the dependent variable exchange rate if India Rupee with the
US Dollar.
Also, the Coefficient of determination R Square of 0.79 explains how well the
independent variables - inflation, interest rates, current account deficit explain the
fluctuations in the Exchange rate.

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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Below is the Exchange rate graph. We can observe that the rates are fluctuating
but post the reforms
of 1991, the Exchange rate has been more or less stable between 45 Indian
Rupees to 55 Indian Rupees for 1 US Dollar.

10. Recommendations/Suggestions
1. Measures by RBI:
a. Using Forex Reserves: RBI can sell forex reserves and buy Indian Rupees
leading to demand for rupee. But using forex reserves poses risk also, as using
them up in large quantities to prevent depreciation may result in a deterioration of
confidence in the economy's ability to meet even its short-term external
obligations. And not using reserves to prevent currency depreciation poses the risk
that the exchange rate will spiral out of control. Since both outcomes are
undesirable, the appropriate policy response is to find a balance. Recent data
shows that RBI had indeed intervened by selling forex reserves selectively to
support Rupee.

Source:RBI
b. Raising Interest Rates: The rationale is to prevent sudden capital outflows
and ultimately lead to higher capital inflows. But Indias interest rates are already
higher than most countries. This was done to tame inflationary expectations. So
further raising interest rates would lead to lower growth levels.
c. Make Investments Attractive- Easing Capital Controls: RBI can take steps to
increase the supply of foreign currency by expanding market participation to
support Rupee. RBI can increase the FII limit on investment in government and
corporate debt instruments. It can invite long term FDI debt funds in infrastructure
sector. The ceiling for External Commercial Borrowings can be enhanced to allow
more ECB borrowings.
2. Measures by Government: Government should take some measures to bring
FDI and create a healthy environment for economic growth. Key policy reforms that
should be initiated includes rolling of Goods and Services Tax (GST), Direct Tax
Code (DTC), FDI in aviation and retail, Companies Bill and diesel decontrol. Efforts
should be made to invite FDI but much more needs to be done especially after the
holdback of retail FDI and recent criticisms of policy paralysis. The government
took steps recently to loosen rules for portfolio investment in the Indian market,
indicating its desire to sustain external inflows. The measure to increase External
Commercial Borrowings (ECB) to $10bn will help in borrowing in dollar at a less
cost. It may take similar steps to encourage FDI as well, helping sustain external
funding.

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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11. Conclusions
The initial success story of India was clearly based on factor driven economy based
on labour arbitrage that is providing low cost labour in comparison to another
country. At this stage development is sensitive to global business cycle and
exchange rate fluctuation. We need to move towards being investment driven
economy that is efficiency driven in the form of infrastructure development,
improving skill of work force and make that investment which translate into tangible
productivity across the board. Final stage which can make India to be developed
economy is to be innovation driven economy that can create unique value of India
at global economy level. We need to accelerate reform process that would make
economy resistant to external shocks and changes in economy cycles and currency
fluctuations. The bottom line is our policy should concentrate on enhancing our
capability in manufacturing, promote entrepreneurship and provide incentive for
innovations. We need to remember that the challenge which we are facing is not
only about currency risk but it is about moving to growth and development.
The Indian Rupee has depreciated significantly against the US Dollar marking a new
risk for Indian economy. Grim global economic outlook along with high inflation,
widening current account deficit and FII outflows have contributed to this fall. RBI
has responded with timely interventions by selling dollars intermittently. But in
times of global uncertainty, investors prefer USD as a safe haven. To attract
investments, RBI can ease capital controls by increasing the FII limit on investment
in government and corporate debt instruments and introduce higher ceilings in
ECBs. Government can create a stable political and economic environment.
However, a lot depends on the Global economic outlook and the future of Eurozone
which will determine the future of INR.

12. Scope for Further Research

Due to the limitations in the number of words we were only able to perform
regression on 3 factors affecting the Exchange rate of Indian Rupee. We can
further add other major factors to explain the volatility of Indian Rupees
exchange rate. Certain factors like public debt, gold reserves, FII, FDI, foreign
exchange reserves, bank rates, trading terms, etc., can be added to the
independent factors and a multiple regression of the same can give a better
picture of the dependence of exchange rate on these factors. There are
several other factors which influence the exchange rate like socio-economic
policies, political scenarios etc., but many of them are out of scope of
mathematical correlations as they are not measurable easily.

13. Acknowledgments
Factors affecting the fluctuations in exchange rate of the Indian Rupee

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We are highly indebted to Great Lakes Institute of Management for giving us

the opportunity to undertake this project in the capacity of the course
Macroeconomics.
We are very grateful to our Professor Dr. Rakesh Singh for enabling us to
understand the world economy and enlightening us about the current and
past economic trends.
We are also obliged to Dr. Muthuraj for his continuous guidance.
We as a team are thankful to each other for our continuous efforts in
contributing to the project.

14. References

15.

http://www.iioa.org/pdf/17th
%20Conf/Papers/4743149_090505_155551_INPUT_OUTPUT_MODELING_OF_IMPA
CT_OF_EXCHANGE_RATE_FLUCTUATIONS_ON_INDIAN_ECONOMY.[1].PDF
http://www.quandl.com/WORLDBANK-World-Bank/IND_NY_GDP_MKTP_CN-IndiaGDP-current-LCU
http://www.quandl.com/WORLDBANK-World-Bank/IND_BN_CAB_XOKA_GD_ZSIndia-Current-account-balance-of-GDP
http://www.quandl.com/WORLDBANK-World-Bank/IND_FR_INR_LEND-IndiaLending-interest-rate
http://www.quandl.com/WORLDBANK-World-Bank/IND_NY_GDP_DEFL_KD_ZGIndia-Inflation-GDP-deflator-annual
http://golak.tripod.com/icfai_ex_rate.pdf
http://zenithresearch.org.in/images/stories/pdf/2012/March/ZIJBEMR/22_ZIJBEMR_
MARCH12_VOL2_ISSUE3.pdf
http://www.indiastat.com
http://www.rbi.org.in
http://www.tradingeconomics.com

Appendix/Annexure

Assumptions:
1. We have assumed that all the other factors that influence rupee fluctuation
besides Interest Rates, Inflation, and Current Account Deficit (CAD) are held
constant.
2. We have considered the period since when India has opened for
Liberalization, Privatization and Globalization (LPG) i.e., 1991 onwards.

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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We are attaching the graphs of the three dependant variables in the following pages
to give a better picture of how these variables have been fluctuating in the recent
past.

Factors affecting the fluctuations in exchange rate of the Indian Rupee

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Factors affecting the fluctuations in exchange rate of the Indian Rupee

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