Relating exchange rate and inflow of foreign direct investment in India

By Indra Giri & Priya Chetty on December 21, 2016

Foreign Direct Investment (FDI) is an international flow of capital where a company or individual of one country makes an investment in another country. The main objective of such investment is to establish business operations that will generate a lasting interest in the investee economy (Goldberg, n.d.). India is one of the most promising economies in the world and in 2015 India received the highest amount of foreign investment leaving behind China and the United States (Unctad, 2016). There are various factors that affect the inflow of foreign investment. Some of the factors have been explained in our previous articles. In the current article relationship between exchange rate and foreign direct investment will be discussed in the Indian context.

The exchange rate is defined as the price of one currency in terms of another currency, by taking into consideration their levels and their volatility (Goldberg, n.d.). According to the Asset Market Approach, exchange rates vary according to the variation in the supply and demand of financial assets of different nations. There are many other reasons also responsible for exchange rate fluctuations, such as;

  • interest rate
  • inflation rate
  • money supply
  • economic growth
  • foreign debt

Factors behind depreciation of the Indian currency

In recent times, the Indian currency has experienced considerable depreciation in its value. It is essential to understand the factors behind depreciation. A low value of Indian currency is affecting both higher and lower sectors of the economy. The main reason for currency depreciation in India is the mismatch of demand and supply between the American dollar and the Indian rupee. Some of the major reasons include:

Increasing exchange rate of Indian currency against American US dollar
Exchange rate of Indian currency against American dollar  (The Global Economy, 2015)
  • Demand and supply mechanism states that, high demand of dollars in currency market without adequate supply, the rupee will depreciate ceteris paribus (Divakaran & Gireeshkumar, 2014).
  • Demand of oil is increasing in the domestic market every year which and is imported. As the payments made are in dollars. The demand for dollar increases which in turn depreciates rupee (Divakaran & Gireeshkumar, 2014).
  • Indian producers fail to compete with foreign goods and services in terms of quality due to lack of technology advancement. As a result import value for India increases than the export value. This results in the increase in current account deficit which leads to the fall of Indian currency (Narasimhan, 2014).
  • Low foreign exchange reserve means less foreign assets held by the country’s central banks. This also means increase in fiscal deficit. It is the difference between government receipt and government spending. High fiscal deficit  can be regarded as other reasons of the depreciation in the Indian currency in compare to dollar (Divakaran & Gireeshkumar, 2014).
  • High inflation rate in the Indian economy results in the decrease of the purchasing power of rupee which leads to the depreciation in rupee.

Trend of exchange rate in India against major currencies

The exchange rate has a significant role in the Indian economy as it impacts various factors such as return on investor’s portfolio, firm’s profitability and growth of specific sectors amongst various other determinants of the economy. At the time of Independence in 1947, the Indian rupee was at par with the American dollar. However, in the past 67 years, it has depreciated slightly more than 68 times against the American dollar (Arora et al, 2015).

Declining value of Indian currency against Euro
The Indian exchange rate against Euro (The Global Economy, 2015)

The depreciation of the Indian currency is not restricted to the American dollar. The exchange rate has also depreciated against other major currencies too.

Declining value of Indian currency against Japanese Yen
Exchange rate of India against Japanese Yen (The Global Economy, 2015)

For example, 1 Euro was equal to Rs 45.88 in 1991, which has increased to Rs 71.14 in 2015.

Similarly, the exchange rate against the Japanese Yen is also depreciating. The Yen still has a lower value than the India Rupee.

Relationship of exchange rate and foreign direct investment in India

The graphs below present the exchange rate value in India as compared to the total FDI receipts for the time period 1991-2014.

positive relationship between foreign direct investment and the exchange rate
Exchange rate and foreign direct investment in India (The Global Economy, 2015)

As it can be seen in the demonstrations above, there is a positive correlation between FDI and exchange rate in India, i.e. with the increase in Foreign Direct investment every year, the value of Indian currency depreciated against the dollar.

The Johansen co-integration test between foreign direct investment and exchange rate in India also confirms the long term relationship between the two for the time period (1980 – 2015).

This was also the main finding in the study of (Khandare, 2016). In their study, the author concluded that one unit increase in exchange rate leads to a rise in foreign direct investment by 0.605 units in India. Chowdhury & Piyali, 2016, were the most recent researchers to conduct a study on a similar theme. In their study, they examined the impact of currency fluctuation on foreign direct investment. Authors used non-Linear regression analysis using the data for the Indian economy

examining the long term relationship between foreign direct investment and exchange rate
Co-integration between exchange rate and foreign direct investment

They concluded that there is a sharp change in the foreign investment net inflow for a small change in the currency. Azhar, Ullah and Malik (2015) also conduct a similar study. The main findings of the study increased in foreign direct investment is a result of the low exchange rate This is because low exchange rate acts as an encouragement for foreign investors to enter India. Openness in the economy, according to them was a major contributor to the sudden upward trend in foreign investment in India.

Stabilizing the exchange rate volatility

As India is one of the biggest developing countries in the world, a continuous inflow of foreign capital is extremely important. Not only does it reduce unemployment, but it also leads to infrastructure development, technological advancement and overall economic growth. Exchange rate change has an impact on the international wealth of a country. Results from various studies gave strong evidence of a positive correlation. It is suggested that policymakers in India must take into account the fluctuations in exchange rates while framing the foreign policies in the short term. Recently rupee sank to a record low of Rs 68.86 per dollar and the central bank intervened to stabilize.

It is a well-known fact that the exchange rate and inflow of foreign direct investment are positively correlated. However, it is important to have a stable exchange rate. A high value of Indian currency may negatively impact the Indian exports and low foreign investment whereas the low value of the currency may have a negative impact on the overall current account and fiscal deficit. So the government and central bank should focus on balancing both the factors while making the policies. Especially the monetary policy.


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