Global Factors That Influence The Foreign-exchange Rate

Few of us could claim to be expert economists, but most of us have at least a basic understanding that currency exchange rates around the world affect each other and that the levels change regularly. There are many reasons that a nation's currency exchange rates can strengthen or decline.

Rates reflect the relative value of a currency against another world currency. Rates are expressed as a ratio compared to another currency. For example - 1 US Dollar = 105 Yen. These rates fluctuate a little each day, and sometimes they can rise or fall dramatically depending on what it is happening in international traded and economics.

Supply and demand of the currency is one of the key factors determining the exchange amount. Demand for the currency comes when lots of investors want to invest using that currency. This can be prompted by higher interest rates in a country, which will give investors a better return on their money. Supply of currency can affect the exchange rate in tandem with demand. If there is a lot of people wanting to purchase and not so much currency available the value will be high. On the other hand, if the federal mint prints lots of extra money and releases it into the market place then supply will be higher and demand for the currency can drop, which will make exchange rates drop.

The inflation levels in a country can also affect currency exchange rates. If an inflation level is high, then the currency will be devalued as foreign investors will be less likely to invest in a currency that has a high level of inflation and will not give them a good return over time. The reserve bank monitors the level of inflation, but there are several external factors that influence the inflation level such as the cost of transporting goods and petrol.

It is essential that the nation's treasury gets the trade balance right if a currency is to remain strong. When the prices paid globally for exported products are higher than what the same country is importing, then the economy will be in a good position and the currency will remain strong. Foreign investors will purchase more with that country's currency and the economy will tick along. If the reverse is true, then this devalues the currency against others.

People are affected by exchange rates regularly, as they determine the price that people pay for imported goods in a country. They also determine how popular your country's exported goods are to other countries.

When the trade balance is out and currency exchange rates are not right. Local businesses and producers may be forced to cut costs to remain internationally competitive. This can mean that people lose their jobs and economic stability is affected.

Fixed and Floating Foreign Exchange Rates

Open economies in a global market are confronted with three objectives - stabilizing the exchange rate, enjoying international capital mobility and engaging in a monetary policy tailored for domestic goals.

Unfortunately, desirable as these are, they are contradictory. Fixed forex rates stabilize the rate while engaging in domestically-oriented monetary policy, these don't coincide with enjoying international capital mobility, which is where floating forex rates come in.

Fixed Forex Rates

A fixed foreign exchange rate is when a currency's value is pegged to the value of another currency, group of currencies, or another asset, like gold. Fixed rates were used globally from 1944 to 1973, but now fixed rates are mainly used by small countries with economies that are largely dependent on foreign partners.

Fixed exchange rates are infrequently evaluated for political and economic reasons, either being reevaluated or devaluated. A devaluation in a fixed rate lowers the value of the fixed currency, making exports more attractive to foreign investors as they become cheaper when their value is converted into the investors' currencies. This also discourages imports as imported goods become more expensive due to the forex rate, the ultimate goal being to increase trade surpluses while decreasing trade deficits.

A revaluation raises the value of the fixed currency, causing the opposite scenario to occur.

Floating Forex Rates

Floating foreign exchange rates are when a currency's value changes depending on factors in the forex market, such as the currency's economy, investor sentiment, politics, inflation and interest rate derivatives.

This is the most common regime for major economies with two variants: free floating currencies and managed floating currencies.

The value of free floating currencies is solely determined by forex market forces and can fluctuate greatly, providing opportunities for traders to profit on rising and falling currency values.

Managed floating currencies are allowed to float to a certain extent, and will be reined in by the central bank if it travels too far from ideal levels.

That being said, every floating rate is managed, at least slightly. If a currency goes too far off course, that country's central bank will respond by changing interest rates or by buying and selling large amounts of currency to bring its currency back to acceptable levels.

Fixed vs. Floating Forex Rates

Fixed exchange rates benefit from reduced risks in international trade and investment as international buyers and sellers can agree to a price that won't be vulnerable to forex rate changes. Fixed rates can introduce stricter economic management, keeping inflation under control, and they can also reduce speculation, which can be destabilising to less-established economies.

However, the disadvantages of fixed rates are that there is no automatic balance of payments between nations without government interference; large holdings of foreign exchange reserves are necessary to maintain the fixed rate; the need to maintain the exchange rate can dominate monetary policy, which may be better focused on other things; and fixed exchange rates can be unstable, resulting in different rates of inflation causing imbalances of the levels of competitiveness between different countries.

Countries with floating exchange rates benefit from allowing the market to quickly respond to economic events, as opposed to waiting for the central bank's reaction. As the forex market is open 24-hours a day, free floating currencies can react very quickly to significant news. This also results in automatic correction in balance of payments adjustments as the exchange rates adjust to balance supply and demand.

As this will be taken care of automatically, governments should have more time to devote policy to other matters.

As floating rates change automatically, they don't suffer from international relations crises that can plague countries with fixed foreign exchange rates when pressure mounts on a currency to devalue or revalue.

And countries with floating exchange rates can have lower foreign exchange reserves.

However, floating exchange rates result in instability and uncertainty when it comes to international trade, as fluctuations can result in changing prices for imports and exports. This uncertainty can also lead to a lack of foreign investment. Having said that, this risk can be hedged by trading with forward transactions.

Floating exchange rates can result in undisciplined economic management as inflation is not punished, and governments may follow inflationary economic policies.

However, the downside of this is that severe shocks can cause a currency to plummet, magnifying the economic damage. And, as speculation is higher in floating exchange rate regimes, there is more uncertainty for forex traders and investors. A floating exchange rate can also cause inflation by allowing import prices to rise as the exchange rate falls.

Why Do Currency Exchange Rates Change?

Understanding how currency exchange rates work is important for businesses, investors, currency traders and, of course, vacationers. But what causes currency exchange rates to fluctuate up and down? FWD breaks down the world of currency exchange, from the fundamental to the complex.

Here are the 10 main factors that affect currency exchange rates:

1. Supply and Demand

Currency can be bought and sold just like stocks, bonds, or other investments. And just like these other investments - and almost anything else you can buy or sell - supply and demand influences price. Supply and demand is one of the most basic economic principles, but nevertheless can serve as a good starting point to understand why currency exchange rates fluctuate.

2. Political Stability

Currency is issued by governments. In order for a currency to retain its value (or even exist at all) the government which backs it has to be strong. Countries with uncertain futures (due to revolutions, war or other factors) usually have much weaker currencies. Currency traders don't want to risk losing their investment and so will invest elsewhere. With little demand for the currency the price drops.

3. Economic Strength

Economic uncertainty is as big of a factor as political instability. A currency backed by a stable government isn't likely to be strong if the economy is in the toilet. Worse, a lagging economy may have a difficult time attracting investors, and without investment the economy will suffer even more. Currency traders know this so they will avoid buying a currency backed by a weak economy. Again, this causes demand and value to drop.

A strong economy usually leads to a strong currency, while a floundering economy will result in a fall in value. This is why GDP, employment levels and other economic indicators are monitored so closely by currency traders.

4. Inflation

Low inflation increases the value of a currency, whereas high inflation usually makes the value of a currency drop. If a candybar costs $2 today, but there is 2% inflation then that same candy bar will cost $2.02 in a year - that's inflation. Some inflation is good, it means that the economy is growing but, high inflation is usually the result of an increase in the supply of currency without an equal growth in the real value of a country's assets.

Think of it like this, if there is more of something then it's usually worth less - that's why we pay so much for rare autographs and collectors' items. With more currency in circulation the value of that currency will drop. Inflation results from a growing economy, this is why China, India and other emerging economies typically have high growth and high inflation - and their currencies are worth less. Zimbabwe experienced hyperinflation throughout the late 1990's and 2000's reaching as high as 79.6 billion percent in 2008, rendering the currency near worthless.

But wait, right now many European countries have low, or even negative inflation so how is it that the euro is dropping? Well, inflation is just one of many factors which impact currency exchange rates.

5. Interest rates

When the Bank of Canada (or any other central bank) raises interest rates it's essentially offering lenders (like banks) a higher return on investment. High interest rates are attractive to currency investors, because they can earn interest on the currency that they have bought. So when a central bank raises interest rates investors flock to buy their currency which raises the value of that currency and, in turn, boosts the economy.

But remember, no one single factor influences currency exchange. Often times a country will offer a very high interest rate but the value of that currency will still fall. This is because despite the incentive of profiting from a high interest rate, traders may be wary of the economic and political risks, or other factors - and thus refrain from investing.

6. Trade Balance

A country's balance of trade (meaning how much a country imports vs how much that country exports) is an important factor behind exchange rates. Simply put, balance of trade is the value of imports minus the value of exports.

If a country has a trade deficit, the value of their imports is greater than the value of their exports. A trade surplus occurs when the value of exports exceeds the value of imports.

When a country has a trade deficit it needs to acquire more foreign currency than it receives through trade. For example, if Canada had a trade deficit of $100 to the US it would have to acquire $100 in American currency to pay for the extra goods. What's more, a country with a trade deficit will also be over-supplying other countries with their own currency. The US now has an extra $100 CND that it doesn't need.

Basic supply and demand dictates that a trade deficit will lead to lower exchange rates and a trade surplus will lead to a stronger exchange rate. If Canada had a $100 trade deficit to the US then Canadian demand for USD would be high, but the US would also have an extra $100 Canadian so their demand for CAD would be low - due to excess supply.

7. Debt

Debt, specifically public debt (that is the debt incurred by governments) can also greatly affect interest rates. This is because a large amount of debt often leads to inflation. The reason for this is simple - when governments incur too much debt they have a special luxury that you or I don't have - they can simply print more money.

If the US owed Canada $100 the American government could simply run over to the mint, fire up the presses and print out a crisp new $100 bill. So what's the problem? Well, $100 isn't a lot of money to a government nor is $1 million, $1 billion is pushing it but Canada's public debt is over $1 trillion while America's is well over $15 trillion (and grows by $2.34 billion per day). If a country tried to pay its bills by printing money then it would experience massive inflation and ultimately devalue its currency.

Investors will also worry that a country could simply default on its obligations - or to put it another way - be unable or unwilling to pay the bills. This is the precarious situation Greece and the eurozone find themselves in currently.

8. Quantitative Easing

Quantitative easing - usually shortened to QE - is a mouthful, but it really isn't all that complicated. The simplest explanation is that central banks will try to stoke the economy by providing banks with greater liquidity (meaning cash) in the hopes that they will then lend or invest that money and in doing so boost the economy. In order to provide this greater liquidity central banks will buy assets from those banks (usually government bonds).

But where do central banks find this extra cash? The short answer is: they create it. Creating more currency (increasing supply) will devalue it, but it will also lead to economic growth - or so the theory goes.

What's the point of quantitative easing? Central banks will only use QE in times of low growth when they have already exhausted their other options (like lowering interest rates). After the 2008 financial crisis, the US, UK and other countries implemented QE, and the European Central Bank just recently announced that it too will use QE to try to restart the Eurozone economy.

9. Unemployment

Unemployment levels in a country affect almost every facet of its economic performance, including exchange rates. Unemployed people have less money to spend, and in times of real economic hardship high levels of unemployment will encourage employed people to start saving, just in case they wind up unemployed too. Unemployment is a major indicator of an economy's health. In order to boost employment a country must boost the economy as a whole. To do this central banks will lower exchange rates and even resort to more extreme measures like quantitative easing, both of which can negatively impact the value of a currency. This is why currency traders pay such close attention to employment statistics.

10. Growth Forecasts

Most countries aim for about 2-3% growth per year. High levels of economic growth lead to inflation, which can push the value of currency down. In order to avoid devaluing their currency central banks will raise interest rates, which will push the value of a currency up. Growth forecasts are important indicators but have to be carefully weighed against other factors.

Last Words

There are a number of economic forces that affect the way that currency exchange rates perform. Supply and demand, political stability, economic strength, inflation, interest rates, trade balance, debt, QE, unemployment and growth forecasts all interact (and sometimes contradict) each other. Reserve banks in each country work to control the factors as much as possible that affect these rates and provide the best environment possible for a well functioning and effective economy.

Next time you see the financial markets on the evening news, you will know more about what must be happening in the local economy to influence the currency rates.