Exchange rates between currencies can be either controlled as in the case of India prior to the reforms or left to the market to decide, as is the case now in India.
Present : Left on markets to decide...
History: was Controlled by Govt...
In the case of controlled exchange rates, it is quite obvious that the government would fix them, so the question really boils down to what is the process by which markets determine rates.
The supply and demand for different goods determine what their prices are. In this case, substitute currencies for goods. Lets take the case of one foreign currency to understand how this market works.
Thus, the dollar-rupee exchange rate will depend on how the demand-supply balance moves. When the demand for dollars in India rises and supply does not rise correspondingly, each dollar will cost more rupees to buy.
Supply of Dollar????
The supply of dollars comes from several sources.
- One is Indian exporters of goods and services who sell their wares in the international market for dollars.
- Indian immigrant workers abroad who repatriate money to their kin at home.
- The third major source is investments by foreign individuals, companies or institutions in India. This could be in the form of foreign direct investment where they are using the money to create some assets in India or to buy into the equity of an existing company.
- It could also be in the form of portfolio investments where dollars are being brought in to buy assets in the stock markets, for instance, with the purpose of selling these assets when they appreciate in value to book a profit.
- Importers are thus the most important source of demand for dollars.
- Individuals or companies repatriating incomes or profits to their home countries.
- This would include portfolio investors as well as Indian branches of multinationals sending back some of their profits to the parent company as dividends.
- A third source would be Indians investing abroad, whether as firms or as individuals.
With hundreds of billions of dollars in its reserves, the RBI would seem to have the ability to be a major factor in how the dollar moves.
If, for instance, it were to dump a huge amount of dollars in the market, it could dramatically add to the supply and hence reduce the price.
But why it wont intervene??
1. They do not like to interfere too much with market valuation of currencies, though they do try and contain excessive volatility.
2. Everytime the RBI sells dollars, it buys rupees, thus sucking some liquidity out of the system. Given the current liquidity crunch, that is obviously not something it would be very keen to do.
For Exporterssss Golden days are back again.. will ample of $ comin in their pocket.. A sluggish situation for importers.. but still u need to cope with every kind of market..