The foreign exchange rates, just like other financial assets, fluctuate every day as the demand and supply of different currencies changes. These changes in exchange rates affect everyone either directly or indirectly. In this article we will look at some of the important factors that influence the exchange rates. The factors are presented in no specific order.
A country with low inflation rate compared to another country will see its currency appreciate compared to the other country. This is because in the country where the inflation rate is low, the prices of goods and services are increasing at a slower rate. That country’s exports will become more competitive thereby increasing the demand for that currency. At the same time the foreign goods in that country will become less competitive and imports will reduce, thereby decreasing the demand for the foreign currency.
A higher interest rate causes the country’s currency to appreciate. This is because the country with higher interest rates can offer better rates to lenders thereby attracting more foreign capital, which causes the exchange rates to rise.
Balance of Payments
The changes in current account also impact the value of currency. A current account deficit indicates that the country’s value of imports is more than the value of exports. Therefore, to balance the trade it requires more foreign currency than it receives through exports. The country will therefore borrow foreign capital which will increase the demand for foreign currency and the domestic currency will depreciate. This can be changed only by either increasing exports by making the goods more attractive/competitive or by reducing imports.
A country with huge public debt attracts less foreign capital. This is because high public debt leads to increase in inflation which erodes the country’s currency value. Additionally if there is a risk of default by the country, investors will sell their bond holding in the open market. This leads to a depreciation of the currency value.
Political Uncertainty and Economic Instability
This again is related to how foreign investors perceive the prospects of the country. If the country has high political uncertainty or economic instability, it will attract less foreign capital compared to a country that offers high stability to investors.
Sometimes even the governments can intervene to artificially maintain a currency value at a certain level. For example, China has kept its currency undervalued by buying dollars so that its exports are attractive.
The movement in exchange rates is also influenced by the current sentiment in the market. For example, if the general sentiment is that the euro will rise in value, the speculator will start buying Euro to make a profit causing the value of Euro to rise. Similarly if there is speculation that a country’s interest rates will rise, it will cause a lot of speculative activity in the foreign exchange market leading to the rise in currency value.
While these are the most important factors that affect the foreign exchange rates, there are many other complex factors that play their role in determining the exchange rates.