Factors affecting Rupee depreciation or appreciation

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There are different factors that affect the currency movements and all the factors are interlinked with each other. Impact on one will definitely impact one or more other factors. Let's understand these in brief:

1. Current account deficit (CAD): CAD is the result of country's higher imports than exports or where payment is higher than receipts. Gold and crude oil are the two major items In India's import list. The more you spend on these two, the more we need to import these and more will be the demand of dollars and thus more depreciation in rupee.

2. Capital Account flows: Capital account flows comes in the shape of FIIs (foreign Institutional Investors) and FDI (Foreign direct Investments). FIIs invest in Stock market or bonds and FDIs come in with Business opportunities. Looking at the country's weak growth outlook, high inflation, high current account deficit etc. FIIs are taking their money back to their country where they are seeing more growth opportunities and also no currency risk. And FDIs are getting impacted by weak government policies, Red tapism and less parliamentary action. If both these investors come in India then demand for rupee will increase as they will bring in dollars to convert into rupees which provide stability to rupee.

3. Interest rate and inflation: High interest rates (as in India) attract foreign investors as they get less rate of interest in their own country , but high interest rates hit local industry and their cost of capital increases. High inflation and interest rates makes our export costlier and thus reducing the demand of our products outside which means less exports. This in turn increases the Current Account deficit and thus rupee depreciation. The unstable currency movements make foreign investors wary of their decision and they prefer to move out of such country.

Let's understand it with an example:

One FII invested $ 1 million on 25^th June'2012 in Indian market and earned 10% return on its investment. The dollar rate was Rs 52, so it invested around Rs 5.2 crore in Indian market. But now when it is about to redeem the investments and book profits the dollar price is Rs 60. So the value of its investment which is Rs 5.72 crore, has become 0.95 million dollar after converting into dollar. Which is even less than the capital invested.

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