Over the years, globalisation has opened up doors for international trade, and the market is brimming with opportunities. International trade serves a crucial role in expanding your business operations but at the same time presents one with various risks associated with it. In the forex market, the exchange rate is the price of one currency in terms of another. The exchange rate changes can have adverse effects on the transaction of individuals or corporations that involve forex if not managed well. The challenges could range from different trade policies to forex exposure risks, especially in the export and import industry, which witnesses foreign currencies’ involvement, whether, for payments or financing, exchange rate fluctuation caused by various factors necessitates certain risk-mitigating strategies to be implemented. Export exchange rates or the import exchange rate are directly related to the volatility in the market driven by supply and demand, which at the core, is an amalgamated effect of various driving factors. Depending upon the government’s regulatory stance about their currency exchange rates can be free-floating, fixed or pegged. A fixed exchange rate is pegged or linked to a stable currency or asset itself, ensuring its stability and protection against the rapid fluctuations. The market forces of demand and supply determine the currency rate in floating exchange rate systems.
Exchange Rates’ impact on foreign trade
The exchange rate can directly impact foreign trade as the fluctuating value of a country's currency will automatically enforce one involved in foreign trade to pay more to compensate for the larger gap in the value of the two currencies. Foreign trade consists of a business relationship spanning countries; the exchange rate holds influencing power specifically for the import-export industry. The balance of payments gets affected due to changes in export and import prices affected by exchange rate fluctuations. A weakened currency boosts exports due to the decreased prices or export exchange rate with foreign currency moving in and domestic goods moving out of the country. On the other hand, the depreciating currency renders the imports expensive, affecting the balance of imports and exports in a country eventually.
For example, with the strengthening of the U.S dollar, the respective exports become expensive causing the consumers abroad to pay more for the same product and the businesses that have to pay in other currencies will acquire lesser profits since to compensate for the value gap ultimately weakening the exports. While it may appear from the example that the U.S business will acquire higher gains directly related to currency appreciation, the ground reality differs from what is perceived on the surface level. The increased U.S dollar prices, in this case, can present a situation wherein the American made products become costlier than the imported goods, causing a shift in consumerism.
Here is an example that elucidates the impact of exchange rates on a country's imports. Suppose a trade relationship between the US and India where electronic components priced at $10 each are exported to India, during which the current exchange rate is 50 rupees to the US dollar. The current exchange rates would dictate the amount payable by the Indian importer, the buyer, to the overseas entity situated in the US, which amounts to Rs. 500 in this case. In a situation where the dollar strengthens against the Indian rupee, it will impact imports' costs due to the weakened domestic currency. If the dollar appreciates to $1=55 INR, then the price of imports would increase to Rs. 550 ($10x55), from an initial borne cost of Rs. 500 that too in an ideal case of the exporter not increasing the electronic component's price. This results in a situation where Indian importers have to pay more to compensate for the value gap in currencies or search for cheaper alternatives from other locations. Thus, a weaker currency would cause imports to decline due to becoming more expensive, indicating the higher value of a foreign currency than the home currency.
Impact of exchange rate on economic growth
Currency fluctuations are the norm for major economies that are an outcome of the floating exchange rates influenced by the geopolitical and economic conditions of a country, interest rate differentials, inflation, and other determinant factors. The economy’s strength and weakness determine the currency's exchange rate, which extends challenges to individuals who have forex transactions as a part of their personal and professional operations. Fluctuating currency and exchange rates can affect the economic growth of a company in the following ways:
Far-reaching impact- A strong currency can impose adverse effects on the economy over the long term due to industries being rendered noncompetitive. In contrast, a weaker currency can result in more economic benefits eventually. While setting monetary policy, central banks emphasize the domestic currency's value in the foreign exchange market and take it as a matter of key consideration.
Merchandise Trade- A weak and strong currency influenced by the exchange rates can contribute to a nation's trade deficit or trade surplus. The imports and exports of a country encompass the merchandise trade wherein imports become more expensive when the currency weakens. At the same time, the exports witness a boost by making the goods cheaper to be bought by overseas customers. Conversely, a stronger currency can cause a trade deficit to widen further eventually weakening the currency due to reduced export competitiveness and cheaper imports damaging the export-dependent industry due to an unduly strong currency.
Economic Growth- A nation's GDP is higher if net exports are higher, which has an inverse correlation with the domestic currency's strength and exchange rate fluctuations.
Inflation- A decrease in currency value of a country can lead to "imported" inflation for extensive import countries. A 20% decline in a domestic currency's value would result in import costing more by a margin of 25% as that 25% increase is needed to get back to the original price point.
Interest Rates- Exchanges rates and how the domestic currency will fare in it are central banks' key considerations when setting monetary policy. A drag is experienced by the economy when the domestic currency is strong, which achieves higher interest rates similar to a tighter monetary policy. Further tightening the monetary policy at the time when the domestic currency is already strong can aggravate this by luring in foreign investors looking for high yielding investments further strengthening the domestic currency.
How does balance trade impact foreign exchange rate?
The terms of trade of any nation are dictated by the comparison of the export prices with import prices wherein if the country witnesses a trade surplus caused by the rise in export prices at a greater magnitude than imports, the term of trade gets favourably stimulated leading to currency appreciation. In contrast, the trade deficit, which is the opposite case causes the currency's value to decrease. Whenever a country's trade account does not net to zero, when exports are not equal to imports, there is relatively more supply or demand for a country's currency, which impacts that currency’s price on the world market.
These relative values are influenced by the demand for the currency, which is, in turn, influenced by trade. If a country exports more than it imports, there is a high demand for its goods, and thus, for its currency. The economics of supply and demand dictates that when demand is high, prices rise and the currency appreciates in value. In contrast, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.
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