Despite the weakening of rupee, it has held fort against most of the currencies. Here is an explainer on how not all is gloom and doom with the Indian currency:
IS RUPEE THE WORLD’S WEAKEST CURRENCY AT PRESENT?
Although the Indian rupee has fallen significantly against the American dollar, it is not the weakest currency. If one compares the exchange rate over a five-year period, it works out that the rupee has appreciated against most currencies.
It is, however, to be noted that despite the appreciation against other currencies, a weak rupee against the dollar will have a significant impact on our trade as dollar is the currency in which majority of international transactions are done. The US dollar, on the other hand, has appreciated against most other major currencies.
WHY IS THE DOLLAR APPRECIATING?
There are many reasons linked to the US’ internal matters that have increased the exchange rate of the dollar against other currencies. The American Federal Reserve (central bank) ended its expansive monetary policy after the American economy started recovering from the 2008 financial crisis. This meant that the rate at which the currency in supply was increasing was slowed down. Because of lower supply, the demand went up, increasing the value of the US dollar.
Apart from this, the American central bank also increased the interest rate while the European Central Bank did the opposite. That means there will be a higher return on dollar deposits as compared to the euro, which again pushed up the demand for dollars and increased its value.
WHO FIXES THE INTERNATIONAL EXCHANGE RATE?
Mostly the market forces of demand and supply. Nearly all countries follow a floating exchange rate to determine the value of their currency against others. This basically means that a currency is worth the value that a buyer is willing to pay for it. The value is largely decided by market forces and depends on a range of factors like economic stability, inflation, foreign trade and so on.
WHY IS US DOLLAR THE CURRENCY MOST IN DEMAND?
The American dollar is among the most prominent global currencies, meaning it is among the most accepted currencies for international transactions. Because of its role in international trade, most countries maintain a foreign exchange reserve in US dollars, pushing up its exchange rate. According to the latest estimate by IMF, the American dollar constituted 62.5 per cent of global forex reserves. It was followed by euro, yen and British pounds.
WHAT ARE REER AND NEER?
The simplest process of fixing the exchange rate would require a comparison of the purchasing powers of two currencies. Factors like inflation, however, can affect purchasing power.
To understand the actual value of currencies, the central banks calculate two exchange rates. The Nominal Effective Exchange Rate, or NEER, is a weighted average of exchange rates of the currencies of all trading partners of a country. NEER determines how much foreign currency may be exchanged for a country’s currency.
This, however, doesn’t reflect the actual purchasing power of the two currencies. For instance if India has a higher inflation as compared to US, then the rupee exchanged for dollars will buy fewer goods. To eliminate this, Real Effective Exchange rate – REER is calculated by adjusting NEER to inflation in both India and its trading partners.