The impact of spot exchange rate - from INR to GBP

From 21 March – 14 June 2016, INR – GBP exchange rate is relatively stable, with the weakest point of 98.77 INR/GBP on 24 May 2016 and the strongest point of 95.0983 INR/GBP on 14 June 2016 (based on the INR perspective). However, on 21 June 2016, there was a sudden increase in the value of GBP from 95.0983 INR/GBP to 99.3489 INR/GBP, putting the INR value at its lowest from the period of 21 March – 21 June 2016.

To analyse fluctuation in exchange rate we can consider the following factors that influence exchange rates movement, which is: e= f(ΔINF, ΔINT, ΔINC,ΔGC, ΔEXP)

ΔINF impact on the exchange rate:

From the perspective of which is the differential between the UK and India inflation rates, we can see that India’s inflation (CPI) rate in June 2016 was 6.13% compared to March 2016 inflation (CPI) 5.51% (OECD, 2021). A steady rise in inflation (CPI) rate throughout March-May 2016 with a slight decline in June 2016 indicates rising prices of consumer goods which also means inflation is taking place.

When we compared this scenario with the UK inflation (CPI) rate, which was 0.80% in March 2016 and the same percentage of 0.80% in June 2016 (OECD, 2021), we can say that the UK inflation (CPI) rate was very stable compared to India’s inflation (CPI) rate. According to (Madura & Fox, 2020), changes in relative inflation rate influence the demand and supply of foreign currencies, eventually affecting the exchange rate between two currencies.

The application of such a theory, in this case, is when the inflation rate was rising from the period of March – June 2016 in India, it increases the demand of British goods to the Indian market due to the high prices of Indian goods caused by rising inflation.

In return, this increases the supply of INR for GBP while also reducing the attractiveness of the Indian goods for the UK customers due to high prices caused by inflation, reducing the supply of GBP for sale in the currency market. The higher demand over the supply of GBP caused INR to depreciate over GBP.

ΔINR impact on the exchange rate:

According to the data by (World Bank, 2021), India’s real interest rate was 6.233% in 2016. The real interest rate is the interest rate after adjustment by inflation. Meanwhile, the UK bank rate from March – June 2016 was 0.5%. Even after adjustment by inflation (since the UK interest rate was significantly lower than India), the India real interest rate is way much higher compared to the UK.

A high real interest rate in India could be due to the high rate of inflation. A rising interest rate can reduce the amount of money circulating in the market, as the cost of borrowing becomes high, and encourage people to save more as people will earn more interest.

As it shows in India’s case, after its lowest period on 21 June 2016, the INR was gradually strengthening in value and the value of INR was stabilised and maintained with small volatility for the period of 2016 – mid-2018. The interesting thing to note here is that the real interest rate of India was declined gradually, following the stability of the INR/GBP rate for over two years. India’s inflation rate was also gradually declined, reached as low as 1.08% in June 2017 before climbing again to 5.61% in August 2018, the same year when India’s real interest rate increased again after two years decline.

The impact of high real interest rate over INR/GBP currency is that during the two years stable period of July 2016 – mid-August 2018 is that more UK investors coming to invest their money in India compared to the UK. For example, the UK bank rate in 2017 was 0.25% compared to India’s 5.2% real interest rate. This creates more supply of GBP for INR and reduced demand for GBP by INR as investors prefer to invest in India due to higher interest rates. As we can see, the long period of stability of INR/GBP was caused by the low inflation rate, high real interest rate and that are reasons why INR was appreciating against the GBP for the period of mid-2016 – mid-2018.

Implications of exchange rate behaviour on companies involved in FDI:

Assume that a UK company conduct FDI in India to cater to the substantial Indian market and customers. When the exchange rate goes up and down, it can affect the number of funds payable and receivable and create an unpredictable fund needed due to constant exchange rate changes.

Hence, a UK company can utilise money market hedging or forward exchange contract to mitigate the risk of exchange rate volatility. For instance, in 2020, the rate was INR 92,6213/GBP. However, by the end of Q4, the rate was INR 99,7294/GBP. If a UK company receives INR profit by the end of Q4, depreciating INR is not good news since it means less value against the GBP and indicates less purchasing power in India. And if we relate this to the inflation chart, as the INR weakened, India's inflation rate increased. Therefore, it makes the Indian market less attractive in 2020 compared to previous years. UK company can compare the value between money market hedging and forward contract and choose the most profitable between the two options. If the UK company desires to receive receivable, it can utilise hedging to get maximum INR value.