Other than inflation and interest rates, the Foreign Exchange rate (ForEx rate) also acts as an important determinant of the overall economic health of a country. Being a window to stability, the exchange rate is the most-watched, analyzed, and often a governmentally-manipulated driver of the economy.
The fluctuating rates of currencies are not only important to governments, financial institutions, and exporters/importers . They also impact the real returns of an investor’s portfolio; it is also important to those who send/receive money abroad.
So, if you are thinking or already used to sending or receiving money from overseas, you should keep an eye on the currency exchange rates. Interestingly, now you don’t need to go to the money exchange to check the fluctuations in any currency, as everything is available online.
So, if you are planning to invest in any forex or want to go abroad, do check its online currency rate before finalizing your tickets.
Anyway, if you don’t know the exchange rate – it is defined as “the rate of one country’s currency into another.” It may fluctuate daily, often hourly, with the changing supply and demand of currencies from a country to another.
For these, and some other reasons, it is very important to understand the factors that trigger exchange rates.
Key Factors Affecting Foreign Exchange Rates
This article examines a few of the leading factors that influence the fluctuations in exchange rates and the respective reasons behind their volatility, helping you learn the best time to send money abroad.
- Inflation Rate
Our purchasing power affects the exchange rate, rising inflation – which means prices of commodities are surging – pushes down the value of the national currency. On the contrary, if the prices of goods and services increase slowly, then the rate of inflation will be very low.
Generally, countries like Canada, Japan, Germany, Switzerland, the U.S., and others, who follow a consistent pattern of lower inflation for the later part of the 20th century, exhibit a rising currency value. It means their purchasing power is more relative to other currencies; their currency can buy more compared to others.
Countries with higher inflation, like Pakistan, typically see the gradual, often quickly, depreciation in their currency in terms of the currencies of their trading partners.
This also, usually goes hand to hand with interest rates.
- Interest/Discount Rate
It indicates the value of money in the country; this is the rate that the central bank charges to financial institutions (including commercial banks) for the loans, which then lend money to businesses and citizens.
When the interest rate is manipulated in an economy, central banks exert pressure over both inflation and exchange rates. Higher interest rates mean lenders will get higher returns relative to other countries.
Therefore, higher interest rates attract foreign investors, which means the flow of foreign capital in the economy, which causes the exchange rate to surge.
But again, if the inflation in the country is higher than in others, along with additional factors, the impact of higher interest rates will be mitigated, and the currency will jump down.
- Government/National Debt
Government debt is public/national debt owed by the central government. Though it is not the major factor, it still plays an important role, especially for emerging markets – an increase in national debt shows weaknesses of the national currency.
In order to pay-off/manage foreign debt/s, an economy needs excessive demand for foreign currency, thereby increasing the value of that country. Higher the default risk, higher the discrepancies among investors, reducing foreign capitals inflows, creating a deficit.
A country with government debt gets an unfavorable response in acquiring foreign capital, and to pay off debts, the inflation in the country rises.
Resultantly, the existing foreign investors sell their bonds in the open market, which increases the supply of the local currency, followed by the value of its exchange rate.
- Country’s Balance of Payments / Current Account Deficits
The current account is the trade balance of a country with its trading partners, reflecting payments of goods, services, interest, and dividends that countries owe to each other. A deficit in the current account means the country is spending more on foreign trade than it is earning, spending more on imports than on exports – and to pay off the deficit, the government needs to borrow capital from foreign sources.
And, the excess demand for foreign currency lowers the rate of the country’s exchange, until domestic goods and services become cheaper for foreigners.
- Terms of Trade
It’s a ratio of export to import prices; it is related to current accounts and the balance of payments – what if the price of a country’s exports rises by a greater rate than that of its imports?
It means it’s favorable. Increasing terms of trade mean greater demand for the country’s exports. This, in turn, results in rising export revenues, which obviously increases the demand for the country’s currency (and its value).
On the other hand, if the exports will rise by a lower rate than that of its imports, then the currency’s value will depreciate compared to its trading partners.
- Foreign-currency and Gold Reserves
It is another tool that central banks use to regulate the supply of money in the economy. If the country’s currency is depreciating and the demand for foreign currencies increases in the domestic market, then the central bank steps in and partially satisfies the demand by selling foreign currencies to the population, to remove the surplus of national money and curb inflation.
And, when a country’s foreign-currency and gold reserves sharply decrease, it leads to a devaluation of the country’s national currency, especially if the central bank is unable to restrain the inflation growth.
- Political Performance and Stability
A country’s political and economic performance can also affect its currency strength. A country with a stable economy with less political turmoil is more attractive to foreign investors, drawing investment away from other countries, especially the ones with less political and economic crises.
An increase in foreign capital leads to an appreciation in the domestic currency. A country with sound trade and financial policies do not give any room for doubts and uncertainty in the value of its currency.
But, if a country is in political confusion, then it may witness a depreciation in exchange rates.
If a country’s currency value is rumored or expected to rise, investors start valuing the currency with hopes to make a profit in the near future, and in turn, the demand of that currency rises, so does its value.
- GDP (Gross Domestic Product) and GNP (Gross National Product)
The growth of these two brings positive effects on the national currency rate. If the GDP rate is high, the country becomes a favorable option among foreign investors; this means the flow of foreign capitals that strengthens the national currency. Having annual GDP growth slower than in the previous terms is a negative indicator.
If a country is experiencing a recession, then its interest rates would be in a falling curve, decreasing the chances of acquiring foreign capital. As a result, its currency will weaken in comparison to other countries; lowering the demand and increasing supply of the currency will push down its exchange rate.
All of these factors described above determine the foreign exchange rate fluctuations; a declining rate decreases the purchasing power of income and capital gains.
Overall, exchange rates are determined by so many complex factors and cannot always be easily explained, so as far as investors are concerned, they need to have some understanding of how currencies and exchange rates play in the economy and their respective rates of return on their investments.