An exchange rate is the rate at which one currency is exchange for a foreign currency. Exchange rates are stated in pairs of currencies between two nations. A domestic currency is said to appreciate against a foreign currency when one unit of domestic currency buys more units of a foreign currency. Likewise, a domestic currency is said to depreciate against a foreign currency if one unit of domestic currency buys few units of a foreign currency.
A country’s exchange rate fluctuates due to changes in demand and supply for its currency from domestic and offshore individuals, corporation and institutions. Several key factors which can impact a country’s exchange rate include export and imports, capital flow, interest rates, inflation rates, sovereign debt level, political outlook and central bank monetary policy.
(a) Exports and imports.
A country’s trade balance is the difference between a country’s exports and its imports. If a country’s export exceeds its imports, it will register a trade surplus. However, if the country’s imports exceed its exports, it will register a trade deficit. Countries with globalization trade surpluses tend to have stronger currencies while countries with large trade deficits tend to have weaker currencies.
(b) Capital Flows
Capital flows are inflows or outflows of funds from a country for the purposes of investment in financial assets, real estate or business enterprises.
If capital inflows exceed capital outflows from a country, the country will register a capital account surplus. If capital outflows exceed capital inflows, the country will register a capital account deficit which is negative for its currency.
Countries with sustained capital account and trade surplus will build up reserves of foreign currency over time.
(c) Interest Rates
A country’s currency is also affected by changes in domestic interest rates vis-à-vis offshore interest rates. If domestic interest rates rise in comparison to offshore interest rates, this will lead to an increase in fund inflows from abroad to capitalize on potentially higher rates return on fixed income instruments, leading to stronger domestic currency.If offshore interest rates rise in comparison to domestic interest rates, this will lead to an increase fund outflows to capitalize on potentially higher rates of return on foreign fixed income instruments, resulting in a weaker domestic currency.
(d) Inflation Rate
A relatively higher domestic inflation rate compared to other countries will dampen the purchasing power of the domestic currency as prices of local goods and services increase at a faster rate than foreign goods, leading to a weaker domestic currency.A relatively lower domestic inflation rate compared to other countries will strengthen the purchasing power of the domestic currency as the prices of local goods and services increase at a slower rate than foreign goods, leading to a stronger domestic currency.
(e) Sovereign Debt level
The level of a country’s exchange rate also depends on its financial position. A large and rising sovereign debt level relative to the country’s economic base as measured by its Gross Domestic Product (GDP) may be a cause for concern to foreign investors as they will less willing to invest in countries with potentially higher levels of default risks on their debt obligation. Thus, countries that manage their debt levels well and which enjoy stronger financial position are likely to experience relatively stronger and more stable currencies.
(f) Political Outlook
A nation which has a stable government is expected to be more attractive to foreign investors and have a stronger currency as there is a lower perceived risk of political change that may adversely affect foreign investors’ investment.
Credit rating agencies such as Standard & Poor’s, Moody’s and Fitch provide credit ratings foe sovereign debt issued by various countries, taking into account the country’s financial position and potential political risk.
(g) Central Bank Monetary Policy
A country’s central bank may intervene in the foreign exchange market by buying or selling domestic currency on the foreign exchange market in order to manage its exchange rate.An expansionary monetary policy generally results in an increased supply of money, lower interest rates and a weaker currency.Similarly, a tightening in monetary policy results in a reduced supply of money and a firmer currency.Higher currency valuations make for less competitive exports, while lower currency valuations can help improve exports and drive the economy forward.
Conclusion
It is important to have an understanding of the factors which affect exchange rates as returns on foreign investments can be impacted by currency movements. An appreciation in the exchange rate of a foreign currency against the local currency will lead to higher investment returns when we convert the foreign investment back into local currency. Similarly, a depreciation in the exchange rate of a foreign currency against the local currency will lead to lower investment returns when we convert the foreign investments back into the local currency.
In view of currency movements, it is advisable that investors have an understanding of the major factors that influence exchange rates as currencies impact the rate of return on their offshore investments. Investors who invest in foreign markets should ensure that their risk appetite and profile are consistent with the potential volatility of their investment due to fluctuations of foreign currencies.
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