Question

India tends to have much higher inflation than Australia and also much higher interest rates than Australia. Inflation and interest rates are much more volatile in India than in industrialised countries. The value of the Indian rupee is typically more volatile than the currencies of industrialised countries from an Australian perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the rupee than for currencies of industrialised countries.

Identify the most obvious economic reason for the persistent depreciation of the rupee.

High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the rupee’s value has declined against the Australian dollar over most years even though Indian interest rates are typically much higher than Australian interest rates. Thus, it appears that the high Indian interest rates do not attract substantial Australian investment in Indian securities. Why do you think Australian investors do not try to capitalise on the high interest rates in India?

Why do you think the bid/ask spread is higher for rupees than for currencies of industrialised countries? How does this affect an Australian company that does substantial business in India?

Answer 1

The obvious economic reasons for the persistent depreciation of the rupee are

1) The immense strength of the dollar index:  

There has been a record setting performance of the U.S equities along with an improvement in the labour market. In such a situation people tend to sell rupees to buy dollars and other foreign currency. The importers and exporters keep their foreign income abroad because they expect the rupee to fall further. This gap in demand and supply leads to more depreciation of the rupee.

2) Low growth and high inflation

The trend of the depreciation of the rupee is further fueled by high inflation and low growth in India.

3) High current account deficit

India's current account deficit has also increased due to the lower capital inflows.

The Australian investors do not try to capitalize on the high interest rate in India as there is uncertainty about India's economic reforms. The low annual growth and high inflation due to high prices of commodities such as food discourage foreign investment. The investors are not confident of investing in Indian securities and tend to keep their money abroad. Thus it appears that the high interest rates in India do not attract substantial Australian investment.

The bid/Ask spread represents equilibrium prices at which the banks buy and sell currencies. Now why this bid/ ask is higher for rupees? Let us look into it through demand and supply.

a). Demand for foreign exchange

b). Supply for foreign exchange

Both the above mentioned ways determine the rate of foreign exchange.

There is an inverse relationship between the foreign exchange rate of a currency and it's demand. As the demand for the rupee is less than the currencies of industrialized countries so it's bid/ ask spread is higher.

There is a direct relationship between a foreign exchange rate of a currency and it's supply. As the supply of rupee is more than the currency of the industrialized countries hence it's bid / ask spread is higher.

In the given scenario it will become less profitable for an Australian company to do substantial buisiness in India.