Important Key Factors that affect Foreign Exchange Rates

Important Key Factors that affect Foreign Exchange Rates

30 Sep 2019 04:51 PM

A country’s economic health is gauged by several factors including gross domestic product, its export and import growth as is indicated by current account or fiscal surplus/deficit, which is a difference in government’s revenue and expenses. Every time the economics of a nation change, the foreign exchange, which is the value of a local currency vis-à-vis a base currency, also changes. The outlook of an economy causes changes in the sentiments and thus causes volatility in the Financial Markets. This causes an increase in the foreign exchange risk. There are several factors which affect the change in foreign exchange rates and increase the currency risk. The foreign exchange markets see a direct impact of the following –

Foreign exchange risk increases due to

  • Interest Rates – It is one of the basic tools which the country’s central bank monitors keeping in mind the pulse of the economy. If the economy suggests a slowdown as indicated by consumer spending, job creation, sale of goods and services, then the country’s central bank will have to watch these data and then make relevant changes by either reducing interest rates (repo rate) or keeping them stable while giving a dovish outlook. This would be to monitor the economy and then take the decision in the upcoming policy meeting keeping in mind the Currency Risk. While higher interest rates attract foreign money. Thus an increase in interest rate appreciates the local currency as higher rate indicate higher returns.
  • Inflation – It is a data point which helps in understanding the rise or fall of goods and services prices in reference to a period before. In India it is measured through wholesale price index (WPI) and consumer price index (CPI). In a developed economy, higher inflation means more consumer spend and demand, whereas in a developing economy, like India a higher inflation would see depreciation in the value of rupee which also sees higher interest rates.
  • Foreign Exchange Reserves – when the interest rates are higher than the other economies, there is likely to be an inflow of foreign funds thus making the local currency appreciates as demand increases. The central bank of the country keeps a track on the Forex Reserves which can include bonds, government securities, equity funds, etc. These reserves are used to maintain liquidity in the system. Also proves as a cushion in uncertain and war like situations.
  • Political Stability – a country’s road to growth is very often determined by the stability in their government. If the president/prime minister is found guilty of money laundering or is being impeached upon, the confidence of the foreign investors fades and this makes them pull out funds already invested in that economy. For example, during Indian Lok Sabha elections earlier this year, the uncertainty on who would be the ruling party, caused foreign funds outflow, whereas once the existing government came back to power, the inflow of foreign funds showed the confidence in the economy. This in turn increased the Foreign Exchange Reserves and this appreciated the Indian Rupee.
  • Current Account – the economy’s currency account is the difference in the exports to imports which are earnings or payments made in foreign currency. A deficit implies more imports than exports as is indicated by Indian current account deficit. The import of oil for regular consumption along with higher oil prices increased the deficit and thus making the Indian Rupee lose its value further. But exchange rate can be lowered till it makes the domestic products cheaper than imports and also generating higher sales and exports as the goods are cheaper in international markets. Thus if cost of raw material is cheap then the exports can be competitive in the international markets.
  • Government Debt – the amount of borrowing by the central bank gives the confidence to the foreign investor, thus if the borrowing is more than required and large deficits are there, there may not be too many who would invest in the country. If the debt is too high, the country’s exchange rate value will also fall.

At all times, the above factors influence the foreign exchange rate and the foreign exchange risk also goes up or down accordingly. Sometimes these factors are interlinked making the impact on the foreign exchange rate deeper and thus associating with Forex Experts would help in understanding the impact of each factor. The management of foreign exchange risk will help in right costing and quoting for better growth of the company.

Thus to mitigate the currency risk, one needs to stay tuned to market happening as and when they happen. In the fast age of technology, it is important to stay abreast of all latest events and economic calendar which would assist in hedging one’s forex portfolio appropriately. Forex news and research report to know the action as it happens. Foreign exchange market is the most volatile and highly fluctuating market amongst the financial markets and one should manage the foreign exchange risk in order to safeguard their benchmarks in order to protect their profits.

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