As crude oil reserves of India are limited, it is a huge importer of crude oil. The foreign exchange outgo for payment of crude oil constitutes a large proportion of its import bill. Thus, it is natural that as and when world price of crude oil rises, India’s import bill rises. Demand for US $ rises and the rupee depreciates. This can be observed from Figure 1 where the green line is price of crude oil and the red line the rupee dollar exchange rate.
Figure 1 :
The relationship is symmetric, but there can be deviations. Depreciation of the rupee has consequences for foreign portfolio investors as they take back less than they bring in. This operates through the covered interest arbitrage condition. Depreciation of the rupee also has implications for currency stability and the central bank does step in to check that is does not depreciate much, too fast. While crude oil is a commodity whose price depends on supply and demand conditions, the exchange rate is also a function of supply and demand for foreign currency. However, the exchange rate is a function of macroeconomic factors which directly and indirectly affect its movements.
Tamal Datta Chaudhuri