How Does The Currency Market Affect The International Trade?

How Does The Currency Market Affect The International Trade?

29 Nov 2019 02:16 PM

Trade across international borders for both exporting and importing is basic necessity for a foreign exchange. One can settle this transaction against products or services or complete the transaction by converting the currency into another. Ideally a trade constitutes a foreign exchange transaction but currency can be traded without any underlying which makes it a risky proposition.

The rate at which the currency is converted to another is determined by market forces and amongst that demand and supply for the currency is the key. Higher volume indicates the sentiment of traders in the current scenario. If the fluctuation in the foreign exchange market rate is not high then it provides great stability to the international traders as their cash flow is certain and forecasting becomes easier. Thus budgeting can be done from future growth perspective. All this helps in minimizing the production costs as planning can be done in advance, thereby making the product or services more competitive.

While doing an international trade, the currency risk is inherent to the markets. If one trades without realizing the effects of currency market risk, one is calling for trouble. Proper measures must be taken to mitigate the currency risks.

Effect of exchange rate on economy

If the domestic currency is strong, then imports become cheaper but that hampers exports, conversely a weaker domestic currency encourages more exports value but imports become expensive. Now import and export have direct affect on the trade surplus or deficit which in turn also affects the exchange rate. If exchange rates do not fluctuate, it creates stability in international trade. This helps the exporters to reduce their production costs and thus prove competitive in international markets while improving quality.

Direct Effects

Any change in the exchange rate will have a direct effect on the prices of goods and services which are produced in the domestic country, relative to those produced overseas. An appreciation in domestic currency will make the local products and services expensive compared to those from other countries. While a falling domestic currency will give an edge to the goods and services as they become cheaper than overseas goods and services.

Indirect Effects

  • Economic activity – with a falling local currency, the products become cheaper thereby increasing their competitiveness. This in turn leads to higher volumes of exports and thus calls for higher employment. But for a rising currency, imports become expensive which should encourage locally produced consumption and reduce expensive imported goods and services. This leads to lower imports and helps in employment and demand generation. Changes in export and import prices influence the demand for goods and services and changes in the national income.
  • Inflation – ideally a fall in currency rate should increase the inflation as the import prices increase and also with increase in local consumption employment increases which in turn sees higher salary and wages. With time, these costs are passed on to the products and services thus increasing inflation.
  • Interest rates – Now when the central bank cuts interest rates, they are not immediately passed on to the customer. In principle, there is lag between the Reserve Bank of India’s cut and the public and private bank’s cut which ultimately leads to lower inflation. Thus a central bank keenly watches out for the exchange rate while setting their monetary policies.
  • Balance of payments – a depreciation in currency leads to higher prices of imports when compared with exports, the export volume increases and volume of import reduces. This has an offsetting effect and reduces the current account deficit. This occurs with a lag and over time, as export and import volumes start reacting, the fall in exchange rate is likely to increase the value of net exports.

Foreign exchange impacts

For international trade, the impact of exchange rate is far reaching and do not come in limelight for occasional transactions like overseas remittances, travel for health or education, etc. Thus a stronger domestic currency may not always be good for the economy. If it has appreciated sharply, it can drag the economy and make it uncompetitive over the long term. From individual retail perspective a stronger currency may be a boon especially when converting to foreign currency, but a weaker currency may reap more economic benefits.

A country’s central bank uses the value of the domestic currency as an important tool while setting its monetary policies. It plays an important role in determining the rate of loans, how much is paid for regular groceries, or the returns one earns on the investment portfolio. Even the employment prospects are determined indirectly through the value of the domestic currency. Thus foreign exchange markets inspite of all the factors incorporate most of the sentiments expected and may still sometimes surprise the investors with the impact on the international trade.

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