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Factors that determine the strength of a currency

One day one of my colleague in office asked about valuation of Pakistani Rupee compared to Indian Rupee. We immediately Googled and found that 1 Pakistani Rupee was equivalent to 0.59 Indian Rupees. We concluded that Pakistani Rupee is cheaper than Indian Rupee. Then somebody questioned that which currency is the costliest. One of my friends suggested to search for Kuwaiti Dinar.

I Googled that as well, the result was 1 Kuwaiti Dinar was equivalent to 211.52 Indian Rupees. Our curiosity increased and we also searched for British Pound. 1 British Pound was equivalent to 99 Indian Rupees. Wild Ideas started floating in and people started comparing everything. Soon one of my colleague came-up with an invention.

Tired of reading? We will speak it for you…

He informed us that 1 Bahamian Dollar was equivalent to 1 US Dollar. To this one of close friend questioned, it means Bahamas has as strong economy as USA? We all fell into silence. It was really an intriguing question for a non-finance person like us. We all colleagues are basically engineers.

So what is the answer? Is it ok to say that countries economic strength is determined by strength of its currency? If yes then it means Bahamas is as strong as USA? But this is not correct. Then what are the factors that determine the strength of a currency. How can a country as small as Bahamas has currency equivalent to USD?

In order to understand this, we will have to study what factors determines currency exchange rates. Once we know this it will not be difficult to understand why 60 INR = 1USD & I Bahamian$=1US$.

Global market controls the exchange rates between currencies. The concept that determines strength of currency is Demand & Supply balance. What does this mean? Take example of USD & Indian Rupee. Demand of USD in India always overpowers supply of USD from India. When demand of USD is more than supply, USD will become stronger than INR.
Factors that determine the strength of a currency

Then how to supply more USD to the market?

In order to supply more USD, India shall first create higher reserves of USD.

One of the fastest ways to create higher reserves of USD in India is by exports. Exporting goods & services from India will bring USD in India. Generally, international trading is done in USD. This will create higher reserves of USD in India.

Another way to create higher USD reserves in India is by increasing Foreign Direct Investment (FDI). Increased FDI means foreign companies bringing their money (FDI) in India seeking growth. FDI will increase in India when foreign companies open their facilities in India. FDI also increases when foreign investors buy Indian stocks from BSE & NSE. FDI can really bring huge USD. But problem with this FDI is that it also exits as fast as it comes-in. So in order to make FDI more reliable, economic policies shall be made attractive for FDI.

Another way to create higher USD reserves in India is by creating skilled workforce. These skilled workforces can work abroad and bring USD in India. These workers earns in USD. They send their earned USD back to India. In India this USD gets exchanged for INR in Indian banks. The exchanged USD adds to the foreign reserves.

Another important way to create higher USD reserves in India is by tourism. When foreign tourists come in India they bring USD. They spend their USD in India to buy goods and services.

How to decrease demand of USD in India?

To decrease demand of USD in India, we shall purchase goods tagged MADE IN INDIA. It means we shall be less dependent on imports. When we import an iPhone we spend USD to get them in India.

When foreign companies open offices in India they send part of their profits back to their own country. They do not send money as INR. The exchange it with USD and then send it back. To present this, we shall create more competition. With increased competition, foreign companies will be forced to use majority of profits in India. The profits will be used to compensate employees, buy assets etc.

Demand of USD also increases when we travel abroad. We exchange INR with USD. This decreases the foreign reserves in India. If we travel less abroad less USD reserves will be consumed.

How Trade Deficit contributes to strength of a currency?

Trade deficit means a country is consuming more USD that its supply. This happened due to misbalance between imports and exports. When we export we bring-in USD in India. When we import we consume USD reserves of India.

Factors that determine the strength of a currency (Trade Deficit)

In India trade deficit is growing. Our increase dependency on import of crude oil is widening the gap each year. Huge amount of taxpayer’s money are spend to import crude oil. List of top 5 imported products in India are as follows:

SL Imported Products As % of Total Imports
1 Crude Oil 39%
2 Precious Metals, Gems 14%
3 Machines 6.9%
4 Electronic Equipment’s 6.4%
5 Organic Chemicals 3.6%

I have presented this list to convey a very special message. Top 2 imported items contribute to nearly 53% of total imports in India. This is factor that determines the weak strength of Indian currency. Do we have no ways to decrease our dependency on Oil? Surely it is a tough task which cannot happen in one year. Probably it will take decades to decrease our dependency on crude oil/petroleum products. It is for us to take the initiate and start buying electric run vehicles. It is also for government to motivate use of alternative source of energy for doing business etc.

Conclusion

A country that imports more than it exports has more demand for dollar. Like India imports more than it exports. This is one reason why 1Indian Rupee is = 60USD. Countries like Bahamas seems like they are not very dependent on imports to support its economy. This is one reason why they have their currency equivalent to 1USD. The strength of a economy is calculated by its GDP and by its currency exchange rate. A country like Bahamas has GDP of only $8Billion, but 1Bahamas$=1US$. While a country like India has GDP of only $1870Billion, but 1INR=60US$. So first conclusion is, exchange rate of currency talks nothing about economic strength. The second conclusion is, the factors that determine the strength of a currency is trade deficit. The bigger is the deficit the weaker a currency will become compared to USD.



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About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

5 Comments on "Factors that determine the strength of a currency"

  1. A country like Bahamas has GDP of only $8Billion, but 1Bahamas$=1US$. While a country like India has GDP of only $1870Billion, but 1INR=60US$. ….. pls correct this 1$=60INR

  2. Nice write up, this is exactly what my president (President Muhammmad Buhari) is working at, but my people are not ready to be patient with him.

  3. Nice article! Cleared my basic doubts.

  4. Does the Gold reserve of the country plays the role of determining the currency strength.

    • WHas our PM read this blog of yours?Coz what he is saying is very similar to your article,but great insight and knowledgeable.

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