IMPACT OF FOREIGN EXCHANGE RATE

Sbmitted to: Mrs. Mahak Goreja

Submitted by: Malvika Suthar and Pallav Jhalani

INTRODUCTION:

FDI is the investment made by the individual or a country in another country for business
purpose in form of capital. The main idea behind such investment is to establish business
activities which will generate a great interest in the investee country. FDI in India is the most
influential resources especially for the emerging sector. FDI helps in exploiting wide range of
opportunities and utilizing the same to attain the desired level of development in nation.

Foreign exchange rate is defined as the price of one currency in terms of other currency, by
taking into consideration their levels and volatility. There are many reasons which are
responsible for exchange rate fluctuations:

1. interest rate
2. inflation rate
3. money supply
4. economic growth
5. foreign debt

RELATION BETWEEN FDI AND FOREIGN EXCHANGE RATE:

Foreign Direct Investment and Foreign Exchange Rate are positively correlated, which means
if one increases the other increases along with it and vice-versa. So when FDI increases (the
value of Indian currency against dollar decreases), the exchange rate increases, not exactly
through the same rate though. Even a small change in exchange rate leads to a comparatively
large inflow of FDI. For a country like INDIA, which is a developing country, foreign currency
is needed for creating additional employment, infrastructure development, buying oil (which
is majorly an import and high on increase in demand due to rising automobile industry and
general industrialization).
Though it is generally accepted that a depreciation in the currency of one country increases
FDI, studies based on an option pricing approach and recent FDI flows data from Japan into
the US suggest that the FDI may decrease as the currency of host country depreciates. The
study examines the effect of exchange rate on the mode of operation of firms. It is found that
the depreciation in the currency of host country will ambiguously raise FDI flows from foreign
firms only if initially the firms are mainly exporting. once they have become multinational, the
depreciation in the currency of the host country may give different effect on the FDI flows. If
the foreign firms have technological advantage, the currency depreciation reduces FDI flows
from the foreign country, however if the foreign firms have technological disadvantage, they
will increase their FDI.

EFFECTS OF CURRENCY DEVALUATION ON INVESTMENT:

A currency exchange rate denotes the value of one currency with respect to another. Most
exchange rate quotations are with respect to the U.S. dollar. Under a fixed exchange rate
system, such as in China, the government determines the devaluation and revaluation of its
currency. In a floating exchange rate system, such as in the United States, market forces
determine currency depreciation or appreciation. Devaluation or depreciation means a decline
in the value of the currency, which affects bonds, stocks, mutual funds and other investments.

BONDS:

The Federal Reserve's Joseph E. Gagnon said that exchange rate depreciation could push up
domestic inflation through higher import prices. Investors would require higher returns to
compensate for the inflation and would expect the Fed to raise interest rates to fight off
inflation, which would push up interest rates even more. Given the inverse relationship between
bond prices and interest rates, a currency crash, which is a rapid fall in the currency, could also
lead to a bond market crash.

STOCKS:

A strong dollar can actually hurt the bottom line of U.S. companies when translating foreign
income, according to currency consultant Bryan Rich. Conversely, a depreciating or weak
dollar increases the exchange rate for foreign-currency denominated sales and profits. A low
dollar could actually help exporters, such as manufacturing companies, because U.S. products
would become more price competitive in overseas markets. This could increase profits and
potentially stock prices. However, as Gagnon suggests, import prices would also rise, leading
to inflation. In an article on the Elon University website, author Desislava Dimitrova cites peer-
reviewed research to state that currency depreciation leads to stock price declines in the short
run precisely because of possible inflation, which is usually a negative for corporate profits and
stock prices.

MUTUAL FUNDS:

The Royal Bank of Canada Global Asset Management website describes the impact of foreign
exchange depreciation and devaluation on Canadian mutual funds holding U.S. and other
foreign stocks. However, the concept applies equally to U.S. mutual funds holding European
stocks or European mutual funds holding Japanese stocks. For example, if the Canadian dollar
or the euro were to fall, the value of Canadian and European investments held by U.S. mutual
funds would decline. However, the currency-related impact is minimal over the long term.

HEDGING:

Hedging protects revenues and profits from currency fluctuations. Rich suggests that most
companies underestimate the impact of currencies and the importance of having a hedging
program in place. Small businesses often do not have the expertise to implement a hedging
program, and some do not believe that hedging is worth the effort. Rich states that about a
quarter of the large companies with foreign currency exposure do not have any hedging
program at all.

Due to depreciation in currency and increase in FDI:

1. All exports to countries with better currencies reduces because the cash flow is lower.
2. For India currency depreciation leads this to current account and fiscal deficit.
3. For Joint venture projects of Indian origin company and FDI investor the value pre-
decided in INR gets impacted and thus is more favourable to the Foreign investing
country than to India.
4. For projects requiring high foreign investment from India (usually means import of
technology/ expertise/ equipments) gets adversely affected as that will become
expensive for India with low currency value.

As India is the biggest developing country in the world it is very important to have a
continuous inflow of Foreign capital, not only increase in FDI reduces unemployment
but it also leads to development, technological advancement and overall economic
growth. Exchange rate has a great impact on international wealth of a country. The
policy makers in INDIA must take into account the fluctuations of exchange rates while
framing the foreign policy on short run. Recently rupees sunk to low to a record of Rs.
72.53 per dollar and the central bank intervened to stabilize.

Current Situation of FDI inflow to India:

In the present situation INDIA is the “Most Attractive Destination” for Foreign Direct
Investment as compared to other countries. INDIA is the best favourable country
leaving behind countries like JAPAN and USA.
Total FDI inflow received in the last three financial years is $114.41 billion. This is
40% more than the previous three financial years (2011-2012 to 2013-2014 when the
total FDI was $81.84 billion).
FDI equity inflow received through approval route was $11.69 billion, which is 64%
higher than the FDI of the last three years.
There are primarily three ways in which capital can flow into the economy. These are
the external commercial borrowings from overseas banks (short term and long term),
investment in capital markets and foreign direct investment in the form of plant and
machinery.
Out of the three forms, it is believed that investment in plant and machinery and other
physical assets is the best indicator of faith that the overseas investor has in the long-
term prospects of the economy. Therefore, developing nations should try and tap this
form of capital investments if they really want to grow in the real sense.
This is where our excess reserves can be put to good use. Given the poor infrastructure
level in the country, the reserves can be used to invest in certain key infrastructure areas
like road and power. This infrastructure along with our cheap and skilled manpower
and also the enormous growth potential in the economy will definitely attract more
foreign capital in the country.
The comfortable position of India's forex reserves is making a lot of people to proclaim
that the capital account convertibility process should be hastened. Capital account
convertibility is nothing but giving someone unrestricted freedom to convert his assets
from one currency to another. Although full convertibility of the rupee has still not seen
the light of the day, there has been a notable progress on the issue.

CONCLUSION:
Exchange rate and FDI are not directly related as a cause and effect relationship. But
exchange rates definitely affect FDI. For countries who have poor rate of exchanges
w.r.t. Dollar the FDI is generally high. As the countries whose currency is weaker than
Dollar, they will have high rate of returns in form of interest as compared to those
countries who have relatively less weak currency. An investor from U.K. will choose
to invest in India as compared to U.S.A. because Sterling Pound will earn higher assets
in India as compared to US.
 When a country’s currency depreciates the real wages decrease and reduces
the production cost relative to those of its counterparts.
 Due to depriciation the interest rates become higher and raising money in
capital market of that country becomes easier.
 Due to lower value of exchange rate, it becomes cheaper to invest and asset
acquisition in those countries.