Introduction
The exchange rate is the price of one country’s currency in terms of another. It determines how much foreign currency one can get for a unit of domestic currency, or vice versa. Exchange rates play a crucial role in international trade, investment, and economic policy. Stable exchange rates are essential for macroeconomic stability, inflation control, and investor confidence.
What is Exchange Rate?
The exchange rate is the value at which one currency is exchanged for another. For example, if 1 USD = ₹83, then the exchange rate between Indian Rupee and the US Dollar is 83.
Exchange rates fluctuate based on market forces or may be controlled by the government or central bank.
Two Systems of Determining Exchange Rate
1. Fixed Exchange Rate System
- The value of the currency is fixed or pegged by the central bank against another major currency (e.g., USD) or a basket of currencies.
- Government or central bank intervenes in the forex market to maintain the peg.
- Advantages: Predictable, stable for trade and investment.
- Disadvantages: Requires large foreign reserves, vulnerable to speculative attacks.
2. Floating Exchange Rate System
- The value of the currency is determined by demand and supply in the foreign exchange market.
- Government does not fix the rate but may intervene occasionally (managed float).
- Advantages: Self-correcting, allows monetary policy independence.
- Disadvantages: Can be volatile and unpredictable.
Latest Issues in Foreign Exchange Stability
Foreign exchange stability is under pressure from several global and domestic factors:
1. Global Geopolitical Tensions
- Wars, trade sanctions, and diplomatic tensions affect capital flows and currency values.
- Example: Russia-Ukraine war impacting oil-importing countries like India.
2. Interest Rate Hikes in Developed Economies
- US Federal Reserve and European Central Bank have raised interest rates to control inflation.
- Capital flows out of emerging markets like India, weakening domestic currencies.
3. High Current Account Deficit
- Import-heavy economies face forex instability due to widening trade deficits.
- Example: India’s increasing oil and gold imports pressuring the rupee.
4. Inflation and Recession Risks
- Global inflation and potential recessions affect investment decisions, putting pressure on currencies.
5. Speculative Trading and Volatility
- High-frequency trading and hedge funds create short-term instability in forex markets.
6. Rise of Cryptocurrencies and Digital Assets
- Alternative currencies like Bitcoin attract capital away from traditional forex markets.
Suggestions to Maintain Foreign Exchange Stability
1. Build Foreign Exchange Reserves
- A healthy level of forex reserves can help the central bank stabilize the currency during volatility.
2. Promote Export Competitiveness
- Encouraging high-value exports can reduce trade deficits and strengthen currency value.
3. Attract Foreign Direct Investment (FDI)
- Stable and investor-friendly policies can attract long-term foreign capital, reducing dependence on short-term flows.
4. Flexible Interest Rate Policy
- Central banks should adjust interest rates in response to global monetary trends to prevent capital outflow.
5. Controlled Liberalization
- Gradual opening of the capital account prevents sudden shocks and speculative attacks.
6. Currency Swap Agreements
- Signing agreements with other central banks helps in times of shortage of foreign currencies.
7. Strengthen Domestic Economy
- Low inflation, strong GDP growth, and financial stability make the currency attractive globally.
Conclusion
Exchange rates are key indicators of a nation’s economic health. Both fixed and floating systems have their pros and cons. With growing globalization, exchange rate management becomes complex and requires a mix of monetary, fiscal, and trade policy tools. By strengthening domestic fundamentals and promoting confidence in financial markets, countries like India can ensure long-term foreign exchange stability.