Have you ever wondered how exchange rates are determined? As one of the leading factors behind the economic health level of any given country, exchange rates are one of the most analysed economic measures on the planet. But what exactly influences currency exchange rates and why are they so important to everyone from governments and large financial institutions to small investors?
Supply and demand dictate foreign exchange rates. For example, greater demand for British goods would see an increase in the value (appreciation) of the Pound. Markets worried about the future of the Eurozone economies would tend to sell Euros leading to a depreciation of the Euro.
10 Factors that influence currency exchange rates:
1. Inflation >
2. Interest rates >
3. Government Debt/Public >
4. Political Stability >
5. Economic Recession >
6. Terms of Trade >
7. Current account deficit >
8. Confidence and speculation >
9. Government intervention >
10. The stock markets >
1. Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services andis 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.
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 contractand 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 neighbouring 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.
How Fexco can help you with exchange rates
Monitoring each of these factors together with current exchange rates can help you to make aninformed decision when it comes to making fx payments for business. You may also have a requirement to make international money transfers for personal reasons.
Whatever your payment requirement, opening a free account with Fexco is your first step to better FX rates and excellent support. There is no obligation to trade until you are ready to do so, and you can access expert guidance from the moment your account is opened.
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