FACTORS INFLUENCING EXCHANGE RATES Exchange rates are relative, and are expressed as a comparison of the currencies of two

countries. The following are some of the principal factors that determine the exchange rate between two countries. 1. Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. 2. Differentials in Interest Rates By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The opposite relationship exists for decreasing interest rates that is lower interest rates tend to decrease exchange rates. 3. Current-Account Deficits The balance of current account reflects all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. The excess demand for foreign currency lowers the country's exchange rate. 4. Public Debt A large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating as determined by Moody's or Standard & Poor's, for example is a crucial determinant of its exchange rate. 5. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

6. Speculation If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. 7. Employment Outlook Employment levels have an immediate impact on economic growth. As unemployment increases, consumer spending falls because jobless workers have less money to spend thereby lowering demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely. 8. Central Bank Intervention The central bank, which regulates a countrys currency market, does intervene whenever it feels it is required to stabilise the market, or to keep market volatility under control. It has been observed that the central bank intervenes in the currency market whenever there is any abnormal movement in the exchange rate, either upward or downward. The central bank buys foreign currency to depreciate the domestic currency, and sells foreign currency when the domestic currency depreciates abnormally. 9. Price of Oil A large portion of Indias import payment is mainly for payment of oil. Whenever there is any hike in the oil price per barrel, the Indian Rupee depreciates against the US Dollar. As such, the Indian Government buys more USD against INR to honor the import liability, resulting in heavy demand for USD. Consequently, the Indian rupee depreciates against USD. 10. Natural Calamities Natural calamities may also affect the currency market for a short period of time. In August 2005, Hurricane Katrina affected the entire region around the Gulf of Mexico. This region contributes around one-third of US oil production and accounts for around half of the nations refining capacity. It affected the prices of crude oil and prices shot up to around USD 70 per barrel in a very short time. Automatically, the oil price increased globally and at the same time affected the exchange rate. Since India had to buy more USD to honor its import liability, the Rupee became weaker by around 60-65 paisa against the USD.