Currency exchange rate - An important factor affecting currency exchange rates - Motilal Oswal

Currency exchange rate: An important factor affecting currency exchange rates

In our previous article, we discussed at length what is currency trading, and how it benefits an investor. We also briefly touched upon how investors and market pundits keep themselves abreast with the latest in global economics to make the best of currency trading. This article will touch upon few of those macroeconomic factors that determine a country’s foreign exchange rate, a number that plays a huge role in global currency trading.
While interest rates and inflation are two important factors that affect a country’s economic health, currency exchange rate plays a crucial role in a country’s trade. No wonder, currency exchange rates are widely watched, scrutinized and manipulated by governments. After all, a higher currency translates into expensive exports and cheaper imports in foreign markets, whereas a lower currency makes a country’s exports cheaper and imports expensive in foreign markets. An appreciated currency exchange rate can be expected to lower the country’s balance of trade, whereas a depreciated currency exchange rate simply increases it.

What factors determine a country’s currency exchange rate?

There are several macroeconomic factors that affect a country’s currency exchange rate, and is mainly related to the trading relationship between two countries. It’s needless to say that currency exchange rates are relative and expressed as a comparison of the currencies of two countries. What also needs to be kept in mind is that a currency’s movement is largely driven by global factors, which may not be under the control of a central banker.
So for a better understanding of the factors that drive changes in the currency exchange rates, let’s look at them as short-term and long-term factors as listed below.

Short-term factors affecting currency exchange rate

Interest rate:
This plays a vital role in the movement of a currency. A weak policy leads to depreciation of the currency, thus resulting in decreased currency exchange rate.
Economic growth:
Investors are naturally inclined towards countries with strong economic growth. A country’s currency exchange rate strengthens when the economic scenario is healthy, and there are expectations that the trend will continue.
Trade balance:
Any economy’s currency movement is largely affected by this alone. A nation that has more exports than imports experiences trade surplus, which in turn results in gain for the currency, which in turn results in better currency exchange rate.
Central bankers always look to curb inflation by increasing interest rates, or vice versa. A rise in rates will support the currency, whereas a fall will cause a fall in demand for the currency, thereby affecting the currency exchange rate.
Commodity imports:
When a country largely depends on commodity imports for domestic consumption, its currency usually tends to fall. For example, the increase in gold imports resulted in trade deficit in India, leading to depreciation in the currency. This resulted in a sharp decline in the currency exchange rate.
Political/geopolitical/natural calamities:
These also have a negative impact on a country’s currency, since the movement of currency that decides currency exchange rate is largely dependent on day-to-day economic data, fluctuations in the global equity markets and change in commodity prices.

Long-term factors affecting currency exchange rate

Economic growth and inflation:
The movement of a currency depends on the expectations of economic growth and inflation over a long period of time. For example, the US economy suffered largely during the financial crisis in 2008. However, the global market pegs the US economy to be bullish, which in turn is strengthening the Dollar index. As far as inflation is concerned, the central bank will always target a lower range as higher inflation results in depreciation of the currency.
Stimulus measures:
The market sentiment for a strong currency changes if stimulus is rolled out to make up for capital deficit. More stimulus results in weaker exchange rate for that currency in the global market.
The bottom-line is that before engaging in currency trading, ensure that your research on the subject matter is thorough. Keep yourself abreast with the latest in currency exchange rates independently, or with the help of a qualified broker. After all, knowledge about the market also reduces the chances of you being duped into trading at the wrong time.

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