Ever wonder how the rate of exchange is decided? Exchange rates are among the most closely watched economic indicators worldwide, serving as a primary indicator of a nation’s overall economic health. But what factors specifically affect currency exchange rates, and why do governments, major financial organizations, and individual investors all find them to be so crucial?
Foreign exchange rates are determined by supply and demand. For instance, the value (appreciation) of the pound would rise in response to increased demand for British goods. The euro would weaken if investors were concerned about the prospects of the economies in the Eurozone.
1. Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services and is usually expressed in percentages. If, for example, inflation was lower in the UK, the purchasing power of the Pound Sterling would increase relative to other currencies. UK exports become more competitive and the demand to purchase Pound Sterling for UK goods will increase.
In December 2022, the inflation rate in the European Union was 10.4 percent, with prices rising fastest in Hungary, which had an inflation rate of 25 percent. As a result, the Hungarian forint is amongst the worst-performing currencies in Central Europe since January 2022.
Research by BNP Paribas indicates that the forint has respectively lost 11 and 23 % of its value against the Euro and the dollar. It must be stated however that inflation is just one of the contributory factors here.
2. Interest rates
There is also a strong correlation between inflation, interest rates and exchange rates.
Governments and Central Banks have the authority to influence exchange rates by increasing interest rates. An example of this is “Hot money”: the higher the interest rate the more attractive the currency offer is to foreign investors.
This involves investors rapidly and frequently moving money from a currency with lower interest rates to a country with higher interest rates, giving a quick return on investment.
3. Government/Public debt
A country’s debt rating is also a factor that influences its currency exchange rate. Public sector projects sometimes require large-scale deficit financing which boosts the domestic economy.
However, foreign investors are less likely to invest in countries with large public deficits and government debt. Fear of a debt default can result in the selling of bonds denominated in that currency by investors, resulting in a fall in the value of the exchange rate.
Governments may also need to print money to pay parts of a large debt, resulting in inflation.
4. Political stability
The strength of a currency can also be influenced by the political stability of a particular country. Foreign investors are more attracted to invest in countries displaying a lower propensity for political turmoil. This injection of foreign investment leads to an appreciation of the domestic currency.
Conversely, unpredictable events leading to unstable conditions in a country mean less foreign investment naturally leading to a depreciation in the domestic currency.
In October 2022, Britain was plunged into economic and political uncertainty following the resignation of the then Prime Minister Liz Truss after only 49 days in office. Her vast planned tax cuts crashed the pound and sent borrowing costs soaring.
The ‘mini budget’ announced by former Chancellor Kwasi Kwarteng would have required an unprecedented extra £411 billion in public borrowing over the following five years, pushing Britain into a crisis not seen since the 2008 financial crash.
5. Economic recession
In theory, when a country enters a recession there is normally a depreciation of its currency. Why so?
Firstly, it is commonplace for interest rates to fall in a recession and when this happens, we see a flow of money out of the country to countries with higher interest rates.
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If for example, Canada entered a recession and money started to flow out of the country, its people would sell Canadian dollars to buy other currencies resulting in a fall in the value of CAD (Canadian dollar). It must be noted that economic and political events in other countries will also influence how a domestic currency moves in times of recession.
For example, in a global recession, the United States may still be seen as a haven for investors (even though it may experience high inflation and low-interest rates) keeping its currency stable or even stronger than other currencies.
6. Terms of Trade
The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the difference between the monetary value of a nation’s exports and imports over a certain time period. The terms of trade will improve if the price of a given country’s exports rises by a greater rate than that of its imports.
A greater demand for a country’s exports means an improvement in terms of trade resulting in rising revenues and, consequently, an increased demand for that country’s currency. This will naturally increase the value of that currency.
7. Current account deficits
The current account deficit is closely related to the terms or balance of trade. The current account measures imports and exports of goods and services but also payments to foreign holders of a country’s investments, payments received from investments abroad, and transfers such as foreign aid and remittances.
If for example, Britain, as a regular trading partner with Canada had a higher current account deficit this could weaken the pound relative to the Canadian dollar. Countries therefore with lower current account deficits will tend to have stronger currencies than those with higher deficits.
8. Confidence and speculation
Political events or changes in commodity prices may cause a currency to fall in value. If speculators believe the Euro will fall, they will sell now for a currency they feel will rise in value. For this reason, sentiments in the financial markets can heavily influence foreign exchange rates.
If the markets are alerted to the possibility of an interest rate increase in the Eurozone for example, we are more likely to see a rise in the valuation of the Euro as a result.
If a US speculator expects the euro to appreciate over the next 5 months, he will contract to buy euros in 5 months at a fixed exchange rate. This is known as a forward contract and this mitigates any risk and losses caused by exchange rate volatility.
9. Government intervention
Governments and Central Banks have the monetary authority to intervene to stabilize a currency by formulating trade policies, printing more money, or increasing and decreasing interest rates. China, for example, is reluctant to allow its currency to appreciate because it will negatively impact its exports.
The Chinese government aims to boost its exports and attract foreign investment by keeping the yuan artificially low. As an export-dependent economy, China does so to compete with neighboring countries like Japan and South Korea.
Given China’s large trade surplus, its central bank, the Peoples Bank of China (PBOC) absorbs large inflows of foreign capital. It purchases foreign currency from exporters and then issues that currency in local yuan currency.
10. The stock markets
Both the stock market and foreign exchange are the most financially traded markets on the globe. To help with price predictions, traders often look for correlations between both markets. The mood of investors is buoyed when a domestic stock market rises as it is an indicator that the country’s economy is doing well.
As a result, there is increased interest from foreign investors and the demand for local domestic currency also increases.
When the stock market is underperforming, a lack of confidence means investors will take their funds back to their own currencies.
What Affects The Exchange Rate Between Countries?
An exchange rate tells you how much of a country’s currency you could buy for each unit of another currency. For this reason, exchange rates are expressed as currency pairs. One of the most commonly quoted currency pairs is GBP/USD – the British pound and the US dollar.
If the market rate for GBP/USD is 1.25, for example, you’d get US$1.25 for each £1 you exchange (assuming you get the market rate, and excluding any fees). You can flip the equation. So, at the same time, the USD/GBP rate might be 0.80, meaning you’d get £0.80 for each US$1 you exchange.
The rate can make a big difference to the amount you get from a currency exchange. In the 18 months between 1 January 2018 and 1 July 2019, £1 was worth US$1.42 at its highest and US$1.22 at its lowest. That’s a difference of US$200 for every £1,000 exchanged at the market rate:
- GBP/USD exchange rate = 1.42: £1,000 = US$1,420
- GBP/USD exchange rate = 1.22: £1,000 = US$1,220
As well as moving or traveling abroad, common reasons to exchange currencies include paying mortgages, funding a child’s education, or preparing for retirement overseas. But currencies are exchanged on a much greater scale for other reasons, including trade – buying goods and services from another country – and investment.
The rising value of a country’s currency versus others may be an indicator of improving economic health. Or at least the prospect of it. If GBP is rising against the USD, for example, it’s in higher demand at that time.
Below are some of the key influences on exchange rate movements.
Interest rates and inflation
Inflation and interest rates are closely related, and both affect exchange rates. Some inflation – rising prices of goods and services – is healthy for an economy, as it shows increasing demand versus supply. But too much inflation can be a problem, as goods and services become less affordable.
Central banks consider this balance when setting interest rates. For example, the Bank of England has an inflation target of 2%, as of 22 May 2020.
If inflation is below its target level, a central bank may look to cut interest rates. Lower interest rates make it cheaper to borrow, and less rewarding to save, which encourages people to spend. That increase in demand can push inflation higher.
But if inflation is rising too fast, a central bank may increase interest rates, aiming for the opposite effect. Higher rates can make it more expensive to borrow, and more rewarding to save, reducing demand and slowing inflation.
Higher interest rates can increase a currency’s value. They can attract more overseas investment, which means more money coming into a country and higher demand for the currency.
Trade
A country’s trading relationship with the rest of the world can also affect its currency. Countries that export more than they import – known as a trade surplus – will typically have stronger currencies than those with trade deficits.
If businesses outside the UK buy goods and services from the UK, for example, they’ll typically pay for them in pounds. The more a country exports, the higher the demand for its currency will be.
Market expectations
Market expectations – taking into account the above factors – play a big part in exchange rate fluctuations. But an unexpected interest rate cut, or increase, could have a more pronounced effect on exchange rates.
The Bank of England holds regular Monetary Policy Committee meetings, where it decides whether to raise, cut, or leave rates unchanged. Similarly, in the US, the Federal Open Market Committee (FOMC) holds regular meetings to discuss monetary policy, including interest rates.
Other economic data, such as Gross Domestic Product (GDP) and unemployment rates, will also affect market expectations.
The stability of a country – economic and political – does too. The outcome of an election could have a significant impact on a country’s currency if the market expects it to result in faster or slower economic growth.
Final Words
Similar to an iceberg, the majority of the effects of changes in exchange rates are hidden beneath the surface. Due to its enormous short- and long-term effects on the economy, the indirect effect of currency volatility is much greater than the direct effect. The prices you pay at the grocery store, the interest rates on your savings and loans, the returns on your investment portfolio, your chances of landing a job, and perhaps even the cost of housing in your neighborhood are all indirectly impacted by exchange rates.
