Besides other factors like inflation and interest rates, foreign exchange rates serve as one of the measures for determining the economic health of a country. The foreign exchange rate is the rate of conversion of one country's currency into another country's currency. With the growing opportunities for participation in foreign markets, a booming environment has been created for overseas trade involving the exchange of foreign currencies by organisations and individuals for personal or professional purposes. International trade interlinks the global economies wherein the foreign exchange rates dictate the trade's profitability for individuals and corporations.
The higher strength of economies and currencies is reflected by the relative value gap in the foreign exchange rates of two different currencies, ultimately influencing the value one derives from their forex transactions. The foreign exchange rates influence a country's level of trade due to the impact the fluctuations in the forex rates hold over the value of the exports and imports of a country and thereby its trade relationship with other nations.
What causes the volatility in forex rates? There are several factors like the geopolitical and economic condition of a country, interest rates, inflation and many more that contribute to the volatility of the forex rates. Besides the forex risks encountered by corporations, the forex rate volatility's impact is also observed at smaller levels, including import payables, export receivables, overseas money transfer, forex trading, foreign educational institutions' fees, international travel etc.
Generally, a rise in the currency values is exhibited by a country with consistently lower inflation. The currency appreciations attribute to an increased purchasing power relative to other countries' currencies with whom it might or might not have trade relations. On the other hand, higher inflation in countries demonstrates a depreciating currency compared to their trading partners.
Rapid inflation causes an expeditious decrease in the value of a country's currency. For example, The Turkish economy experienced very high inflation during the 1980s and 1990s, causing depreciation of its economy. However, the efforts made by the government to counter that through export-led growth strategy between 1981 and 1988 pretty successfully brought the average annual growth rate of the real GDP at 5.8 percent.
A critical point for consideration is that interest rates, inflation and exchange rates are highly correlated. The changes in the interest rates brought by government intervention also influence inflation and exchange rates. A higher interest rate in a country attracts investors and an inwards flow of foreign capital by offering them higher returns relative to other countries. This causes the exchange rates to rise, the impact of which is offset by other factors like high inflation that bring the value of currency down. Conversely, a decrease in exchange rates is witnessed in the case of lower interest rates.
Before understanding the impact of interest rates on exchange rates, an important point to remember is that interest rates alone don't determine the value of a currency. The collective effect of the other factors, including inflation, political condition, public debt, etc., influence the exchange rate. One real-world example of this was observed in September 2018 in the case of INR and the US dollar. The massive depreciation of INR against the US dollar made the imports from America, including diamonds, cotton, etc., more expensive for India and reduced the purchasing power of Indian importers. Since the cost of importing goods increased, this increased cost was passed on to the market and reflected as heightened sale prices to Indian consumers.
Any unexpected political development can pose a risk to investors; thereby, the political stability in conjunction with economic performance influences a country's currency's strength. A country with less risk of political turmoil is more lucrative to foreign investors as opposed to a country that has indicators pointing towards political instability, causing a pulling back of investments. It can ultimately lead to the movement of capital to countries with a more stable economic condition and political environment.
For example, the violent protests in Hong Kong against the 'extradition bill' caused a massive blow to its economy. It witnessed huge capital outflows within just a few months of the political turmoil. A great decline in the exchange rates of the Hong Kong dollar was observed, almost forcing Hong Kong to sever its peg to the US dollar due to the difficulty in maintaining the fixed exchange rate by the government.
Economically strong countries with stable currencies are sought out by foreign investors facilitating the inwards flow of foreign capital in countries that display strong economic performance. The countries with such attributes will demonstrate increased demand and value of their currency. In contrast, the countries that are at the forefront of economic development and stability will observe the outwards movement of foreign capital to other nations that exhibit high political and economic stability.
Strong economic performance and low inflation facilitate a strong exchange rate in the long term, whereas short term movement in the exchange rate could be misleading regarding the overall economic condition. For example, After World War II or during the post-war period, Germany and Japan's good economic performance led to a sustained rise in their exchange rates.
While public deficits might stimulate the domestic economy, they are not attractive to foreign investors as they encourage inflation. The lack of enthusiasm of the foreign investors in a country with a huge public debt encompasses the following reasons:
For example, In 2012, the acceptance of a €100 billion loan by Span from the European Commission added about 10 % to Spain's national debt. However, despite Spain being a $1 trillion economy, it was in the midst of depression wherein the Gross National Product was expected to shrink over the next years, which created an increased chance of default with no credible plan for paying back the loan. The euro was adversely affected due to this.
Terms of Trade
Terms of trade is a ratio comparing a country's import and export prices and is related to the balance of payments. When the exports of a country rise at a greater rate than the imports of a country, it is indicative of a favourable improvement in terms of trade and greater demand for the country's exports. Increased demand for the currency due to the rising revenue from exports results in appreciating currency value. On the contrary, depreciation of a currency is observed when the export's prices rise at a smaller rate when compared to the import's prices.
For instance, take an example where $1 = 11 Rand but then became $1 = 15 Rand due to currency depreciation. An American candy cost $1, and South Africa was exporting the candy from America. However, before the depreciation of their currency, they were able to buy one candy for 11 Rand, which now have become 15 Rand for the same candy causing a huge increase in the costs of imports. On the other hand, a South African becomes cheaper in comparison. Thus, the balance of trade is affected as due to the increased price of American candy; the South Africans might start buying fewer dollars, whereas Americans might start buying more rand because of the South African candy becoming cheaper. To reduce the trade deficit, South Africa would then begin exporting more and importing less.
Balance of Payments
Balance of payment is also known as the current account, which is the difference in the exports to imports which are earnings or payments made in foreign currency. A country is said to be in a current account deficit when it is spending more on foreign trade than its earnings which ultimately lowers the exchange rate. In simpler terms, a country with a positive balance of payment witnesses an increase in its currency value, which is not the case for countries with a negative current account.
For example, From 2004, when the current account deficit stood at 0.82 percent of GDP, to 2012, when it widened to 10 percent of GDP, Kenya has witnessed the growth of imports rather than exports largely of goods related to industrial purposes. The increased demand for foreign currency due to import bills and reduced inflow of foreign currency due to slowdown in exports caused the exchange rate to weaken or depreciate because of the combined effect's pressure.
The various factors mentioned above cause the movements of the foreign exchange rates that can prove unfavourable for firms, forex traders, exporters and importers etc. Thus, monitoring the forex rate fluctuations becomes necessary for discerning foreign exchange risks and determining opportunities when the forex rates move in your favour. However, the major implication that a corporation encounters due to forex exposure is the losses in revenue and profits that necessitates the implementation of forex risk management strategies. Understanding the forex market and keeping abreast with the market happenings are crucial for effective forex risk management. Employing professionals or experts' help will enable organizations to safeguard their bottom line by mitigating forex risks due to the implementation of correct hedging strategies. The Dr. Forex (Forex Risk Advisory) service of Myforexeye helps individuals and firms utilize the right hedging strategies while meeting their corporate objectives through strategies that emphasize risk mitigation rather than speculating on forex. Moreover, the other services offered by us include transaction process outsourcing, convenient and secure overseas money transfer, smooth and quick quotes for trade financing, custom alert functions, access to live forex rates, a convenient process to buy and sell forex etc.
Myforexeye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of forex and trade finance, we provide streamlined forex solutions for one’s convenience at their disposal. Corroborating our efforts of providing solutions that are effective to companies for realizing their maximum potential are the latest technology and assistance from the veterans of the forex and trade finance industry. It is our objective to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms - web portal and mobile app, enables one to access the best quotes for all types of forex conversions as well as avail import and export finance and calculate interest costs to make informed decisions.
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