Foreign Exchange Rates are the prices at which one currency can be exchanged for another. They are crucial in international trade, investment, and tourism. Fluctuations in exchange rates can significantly impact businesses, consumers, and governments. Factors influencing exchange rates include economic indicators (GDP, inflation, interest rates), political stability, and global events.
Top 14 factors that influence foreign exchange rates
It is essential to note that exchange rates are influenced by a variety of factors that affect the relative value of currencies. The strengths and weaknesses of a currency are determined largely by the market forces of demand and supply. Let us look at some major factors affecting the exchange rate:
1. Inflation
For the uninitiated, inflation represents the rate at which prices of goods and services increase over time. It affects exchange rates significantly because it impacts the purchasing power of a currency.
When a country has a “lower inflation rate” compared to others, its goods and services become relatively cheaper and more attractive to foreign buyers. As a result, there is increased demand for that country's currency to purchase these goods and services, which leads to an appreciation or increase in the value of the currency.
On the other hand, if a country has a “high inflation rate”, the prices of its goods and services rise faster than those in other countries. This makes its exports:
- Less competitive
and - Under-attractive
Consequently, the demand for its currency reduces, and the value of the currency depreciates.
2. Interest rates
Interest rates are a tool used by the Reserve Bank of India (RBI) to control economic activity. They influence exchange rates by attracting or deterring foreign investment. Let’s see what happens during a surge in interest rates:
- When RBI raises interest rates, it makes saving and investing in that country more attractive
- That’s because the returns on investments are higher
- Higher interest rates attract foreign investors looking to get better returns on their investments
- These investors convert their currency into the domestic currency, say Indian Rupee (INR)
- As more foreign investors buy the local currency, the demand for that currency increases, which leads to an appreciation in its value
Conversely, when interest rates decrease, the domestic currency looks unattractive, which leads to a fall in demand and value.
3. Deficits
A trade deficit represents a situation when a country is buying more goods and services from other countries than it is selling to them. Now, to pay for these imports, the country needs to use foreign currency. This causes the demand for:
- Foreign currency (like USD) to increase
and - Local currency (INR) to decrease
This decreased demand further leads to a depreciation in the value of the domestic currency.
4. Debt
High levels of national debt also significantly impact a country's exchange rate. That’s because these levels impact the:
- Investor confidence
and - Economic stability
Let’s understand in detail:
- Investor confidence
- When a country has a high level of national debt, investors worry that the country might have trouble paying back its debt
- This fear of default makes investing in that country riskier
- As a result, investors get deterred by high debt levels and buy less of the country’s currency
- This again reduces the demand for domestic currency and leads to depreciation
Are you looking to diversify your portfolio? Learn what is commodity trading today.
5. Import-Export
The balance of trade shows how much a country sells abroad compared to what it buys. This relationship directly affects exchange rates. Let’s learn how the situation of trade surplus (exports > imports) acts as a factor affecting the exchange rate:
- When a country exports more than it imports, it has a trade surplus.
- Foreign buyers need the country’s currency to pay for the exported goods and services.
- For example:
- Say India exports a lot of software and tea
- Now, foreign buyers need to buy Indian Rupees to pay for these exports
- This increased demand for the Rupee leads to an appreciation of its value
- In other words, the Rupee becomes stronger relative to other currencies because more people want to buy it
- Thus, we can say that more exports always lead to an appreciation of the value of domestic currency.
6. Economic indicators
The economic health of a nation is a key factor influencing foreign exchange rates. Forex traders and investors closely monitor various economic indicators, such as Gross Domestic Product (GDP), employment figures, inflation rates, and trade balances, to assess a country's economic performance.
Positive economic data can strengthen a currency's value. For instance, a robust GDP growth report may boost investor confidence, attract foreign capital, and lead to currency appreciation. Conversely, poor economic indicators can weaken a currency. Forex markets are highly reactive to economic news releases, and traders often adjust their positions accordingly.
7. Political stability and economic performance
Political stability and a country's overall economic health are crucial factors affecting exchange rates. Nations with stable governments and strong economic fundamentals tend to have more favourable currency valuations.
Political instability, government turmoil, or uncertainty regarding economic policies can lead to currency depreciation. For example, a country experiencing political unrest or frequent leadership changes may deter foreign investors and weaken its currency. Conversely, countries with strong institutions and stable governance typically have more attractive currencies.
8. Market sentiment
Market sentiment, or "risk appetite," can significantly impact forex rates. Traders and investors often make decisions based on perceptions of geopolitical stability, global events, and economic trends. During periods of uncertainty, traders may seek safe-haven currencies like the US dollar, Japanese yen, or Swiss franc, leading to their appreciation.
9. Government/public debt
A nation's debt rating is a significant factor influencing its currency exchange rate. Public sector projects often necessitate substantial deficit financing, which can stimulate the domestic economy. However, foreign investors may be less inclined to invest in countries with large public deficits and government debt. The fear of a debt default can lead to investors selling bonds denominated in that currency, causing a decline in the exchange rate. Governments might also need to print money to service portions of a large debt, potentially resulting in inflation.
10. Terms of Trade
The Terms of Trade (ToT) or Balance of Trade, as it is sometimes known, represents the difference between the monetary value of a nation's exports and imports over a specific period. The terms of trade improve when the price of a country's exports increases at a faster rate than its imports.
A higher demand for a country's exports leads to improved terms of trade, resulting in increased revenue and consequently, a higher demand for that country's currency. This naturally boosts the value of the currency.
11. 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 includes payments to foreign holders of a country's investments, payments received from investments abroad, and transfers such as foreign aid and remittances.
For example, if Britain, a regular trading partner with Canada, had a higher current account deficit, it could weaken the pound relative to the Canadian dollar. Countries with lower current account deficits generally have stronger currencies than those with higher deficits.
12. Government intervention
Governments and Central Banks possess the monetary authority to intervene and stabilize a currency through trade policies, money printing, or adjustments to interest rates. China, for instance, is hesitant to allow its currency to appreciate, as this could negatively impact its exports.
The Chinese government aims to boost exports and attract foreign investment by maintaining an artificially low yuan. As an export-dependent economy, China adopts this strategy to compete with neighboring countries like Japan and South Korea. Given China's substantial trade surplus, its central bank, the People's 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.
13. The stock markets
Both the stock market and foreign exchange are among the most heavily traded financial markets globally. To aid in price predictions, traders often seek correlations between these two markets. A rising domestic stock market can boost investor sentiment, indicating a strong national economy.
This increased confidence attracts foreign investors, leading to higher demand for the local domestic currency. Conversely, an underperforming stock market can erode confidence, prompting investors to repatriate their funds, weakening the domestic currency.
14. Economic recession
Theoretically, a country's currency tends to depreciate during an economic recession. Interest rates typically fall during a recession, causing capital to flow out of the country to regions with higher interest rates.
For example, if Canada entered a recession and capital started to flow out, its citizens might sell Canadian dollars to acquire other currencies, resulting in a decline in the value of the CAD. It's essential to note that economic and political events in other countries can also influence a domestic currency's movement during a recession.
For instance, even amidst a global recession, the United States might still be seen as a safe haven for investors, potentially maintaining or even strengthening its currency compared to others.
Why is the exchange rate important?
The exchange rate plays a key role in shaping a country’s economic health, alongside factors like interest rates and inflation. It affects international trade by influencing the cost of imports and exports. When the exchange rate strengthens, imports become cheaper, while exports cost more for foreign buyers. Conversely, a weaker exchange rate raises import costs, potentially increasing export demand due to lower prices abroad. Additionally, exchange rate volatility influences foreign investments, as fluctuations can lead to changes in foreign direct investment (FDI) and foreign portfolio investment (FPI) levels. During periods of high volatility, non-resident investors may pull back investments to avoid potential losses.
Impact of foreign exchange on the economy
Foreign exchange rates directly impact a country’s trade balance, the difference between its total imports and exports, which is crucial for GDP calculation. A weaker currency can stimulate exports but increases the cost of imports, potentially boosting economic growth and influencing employment. Exchange rate shifts also impact foreign capital flows, such as FDI and FPI, which affect the stability of financial markets and overall economic growth. Thus, currency fluctuations have widespread effects on trade, investment, and the broader economy.
Key takeaways
Forex rates represent the price of one currency in terms of another. There are several factors that influence exchange rates, such as inflation, interest rates, deficits, debt, and import-export balances.
A strong understanding of these factors is important for traders, businesses, and governments. That’s because exchange rate fluctuations impact a country's competitiveness and overall economic stability.
