2013

Factors affecting the fluctuations in exchange rate of the Indian Rupee

Group 9- Section C2
Name
ROHAN RANADIVE SHASHANK SHEKHAR SHREYA GUPTA SMRITI KUMAR SRUTHI BEESABATHUNI SUBHANKAR MISHRA

Roll No.

14460 14463 14465 14466 14467 14468

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. http://www.iioa.org/pdf/17th%20Conf/Papers/4743149_090505_155551_INPUT_OUTPUT_MODELIN G_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
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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 anti-persistent. 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.

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
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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)

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

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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_MARCH12_VOL2_I SSUE3.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 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 :
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Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Exchange rate US Dollar 17.4992 22.689 25.9206 31.4439 31.3742 32.4198 35.428 36.3195 41.2665 43.0552 44.9401 47.1857 48.5993 46.5818 45.3165 44.1 45.307 41.3485 43.5049 48.4049 45.7262 46.6723

Inflation rate 9 13.9 11.8 6.4 10.2 10.2 9 7.2 13.2 4.7 4 3.7 4.4 3.8 3.8 4.2 6.1 6.4 8.4 10.9 12 8.9

Interest Rates 16.5 17.875 18.91666667 16.25 14.75 15.45833333 15.95833333 13.83333333 13.54166667 12.54166667 12.29166667 12.08333333 11.91666667 11.45833333 10.91666667 10.75 11.1875 13.02083333 13.3125 12.1875 8.33335 10.16666667

CAD -3.32797 -2.21065 -2.26688 -3.83708 -2.36251 -2.1431 -1.9839 -2.74219 -3.24596 -3.24203 -3.75975 -4.28679 -4.59156 -3.37521 -3.20004 -3.17788 -2.2429 -0.47062 -4.87021 -5.4187 -3.6432 -3.68215

7. Results & Discussion

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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. 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 shortterm 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

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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.

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
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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
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
http://www.iioa.org/pdf/17th%20Conf/Papers/4743149_090505_155551_INPUT_OUTPUT_MODELI NG_OF_IMPACT_OF_EXCHANGE_RATE_FLUCTUATIONS_ON_INDIAN_ECONOMY.[1].PDF http://www.quandl.com/WORLDBANK-World-Bank/IND_NY_GDP_MKTP_CN-India-GDP-current-LCU http://www.quandl.com/WORLDBANK-World-Bank/IND_BN_CAB_XOKA_GD_ZS-India-Currentaccount-balance-of-GDP http://www.quandl.com/WORLDBANK-World-Bank/IND_FR_INR_LEND-India-Lending-interest-rate

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http://www.quandl.com/WORLDBANK-World-Bank/IND_NY_GDP_DEFL_KD_ZG-India-Inflation-GDPdeflator-annual http://golak.tripod.com/icfai_ex_rate.pdf http://zenithresearch.org.in/images/stories/pdf/2012/March/ZIJBEMR/22_ZIJBEMR_MARCH12_VO L2_ISSUE3.pdf http://www.indiastat.com http://www.rbi.org.in http://www.tradingeconomics.com

15. 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. 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.

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Factors affecting the fluctuations in exchange rate of the Indian Rupee

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