The various determinants of Exchange Rates

Each country’s freedom to choose the exchange rate arrangements best suited to its needs was subsequently codified in Article IV of the Second Amendment to the Articles of Agreement of the International Monetary Fund. The choice of an appropriate exchange rate system is of great importance to a country as it will have important implications for the conduct of its domestic and international economic policy.

The choice of an exchange rate regime might be a relatively simple exercise if countries were faced only with the classical textbook dichotomy of floating and fixed exchange rates. It is well known that some countries with ostensibly floating exchange rates intervene regularly in the foreign exchange market to stabilize the rate, whereas others with pegged exchange rates avail themselves of such wide intervention margins that the currency’s value is determined within very wide limits by market forces. The choice is further complicated by the wide variety of pegging arrangements that have been adopted by different countries. Indeed, sometimes there exists a serious problem in defining unambiguously whether a country’s currency is basically floating or pegged. For instance, the countries adhering to the European currency snake are referred to both.

Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country’s relative level of economic health. Exchange rates play a vital role in a country’s level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor’s portfolio. Here we look at some of the major forces behind exchange rate movements.

Exchange rates determinants: an overview

Before we look at these forces, we should sketch out how exchange rate movements affect a nation’s trading relationships with other nations. A higher currency makes a country’s exports more expensive and imports cheaper in foreign markets; a lower currency makes a country’s exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country’s balance of trade, while a lower exchange rate would increase it.

Forex market is the largest financial market in terms of size. This is so irrespective of the fact that it is fully over the counter market. By far the largest market for currencies is the interbank market, which trades spot and forward contracts. The market can be termed as efficient with enough breadth, depth and resilience.

The basic theories underlying the exchange rates –

1. Law of One Price: In competitive markets free of transportation costs barriers to trade, identical products sold in different countries must sell at the same price when the prices are expressed in terms of their same currency.

Purchasing power parity: As inflation forces prices higher in one country but not another country, the exchange rate will change to reflect the change in relative purchasing power of the two currencies.

2. Interest rate effects: If capital is allowed to flow freely, the exchange rates stabilize at a point where equality of interest is established.

The Fisher Effect: the nominal interest rate (r) in a country is determined by the real interest rate R and the inflation rate i as follows:

(1 + r) = (1 + R)(1 + i)

International Fisher Effect: the spot rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

S1 – S2

———– x 100 = i2 – i1

S2

Where: S1 = spot rate using indirect quotes at beginning of the period;

S2 = spot rate using indirect quotes at the end of the period;

i = respective nominal interest rates for country 1 and 2.

Though the above principles attempt to explain the movement of exchange rates, the assumptions behind these two theories [free flow of capital] are seldom seen and thus these theories can’t be applied directly.

The dual forces of demand and supply determine exchange rates. Various factors affect these, which in turn affect the exchange rates:

The business environment: Positive indications (in terms of govt.policy, competitive advantages, market size etc) increase the demand of the currency, as more and more entities want to invest there. This investment is for two basic motives -purely business motive, and for risk diversification purposes. Foreign direct investment is for taking advantage of the comparative advantages and the economies of scale. Portfolio investment is mainly done for risk diversification purposes.

Stock market: The major stock indices also have a correlation with the currency rates. The Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the dollar as foreign investors purchased US equities. Three major forces affect the indices:

1) Corporate earnings, forecast and actual;

2) Interest rate expectations and

3) Global considerations. Consequently, these factors channel their way through the local currency.

Political Factors: All exchange rates are susceptible to political instability and anticipations about the new ruling party. A threat to coalition governments in France, India, Germany or Italy will certainly affect the exchange rate. For eg. Political or financial instability in Russia is also a red flag for EUR/USD, because of the substantial amount of Germany investment directed to Russia.

Economic Data: Economic data items like labor report (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, productivity, industrial production, consumer confidence etc. also affect the exchange rate fluctuations.

Confidence in a currency is the greatest determinant of the exchange rates. Decisions are made keeping in mind the future developments that may affect the currency. And any adverse sentiments have a contagion effect.

The observers have generally concluded that devaluations should be avoided at all costs, since the panics have almost all followed currency devaluations. Some are of the view that is it not the devaluation, but rather the defense of the exchange rate preceding the crisis that opens the door to financial panic. The devaluation, which follows the depletion of reserves usually, alerts the market to the exhaustion of reserves, a state of affairs, which is not fully apparent to many market participants before the devaluation takes place. Holders begin to convert their money into foreign exchange in expectation of devaluation, and suppose that the central bank defends the exchange rate, by buying high-powered money and selling dollars. Thus, a panic can unfold simply by the belief of creditors that it will indeed occur. In the past four years, mainly three types of events have triggered such panics:

1) The sudden discovery that reserves is less than previously believed

2) Unexpected devaluation (often in part for its role in signaling the depletion of reserves)

3) Contagion from neighboring countries, in a situation of perceived vulnerability (low reserves, high short-term debt, overvalued currency).

Government influence: A country’s government may reduce the growth in the money supply, raising interest rates, and encouraging demand for its currency. Or a government may simply buy or sell forex to maintain stability or to support either exporters or importers. Productivity of an economy: An increase in productivity of an economy tends to impact exchange rates. It affects are more prominent if the increase is in the traded sector. A recent study by the federal reserve bank of New York shows that over a 30 yrs. Period [1970-1999] productivity changes and the dollar /euro real exchange rates have moved in tandem

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.

1. Differentials in Inflation

Inflation:

Inflation in the country would increase the domestic prices of the commodities. With increase in prices exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn would result in the decline of external value of the currency. It may be noted that unit is the relative rate of inflation in the two countries that cause changes in exchange rates. If, for instance, both India and the USA experience 10% inflation, the exchange rate between rupee and dollar will remain the same. If inflation in India is 15% and in the USA it is 10%, the increase in prices would be higher in India than it is in the USA. Therefore, the rupee will depreciate in value relative to US dollar.

Inflation Rates: It is widely held that exchange rates move in the direction required to compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e. stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that an exchange rate is a relative price and hence the market weighs all the relative factors in relative terms (in relation to the counterpart countries). The underlying reasoning behind this conviction is that a relatively high rate of inflation reduces a country’s competitiveness and weakens its ability to sell in international markets. This situation, in turn, will weaken the domestic currency by reducing the demand or expected demand for it and increasing the demand or expected demand for the foreign currency (increase in the supply of domestic currency and decrease in the supply of foreign currency).

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

Empirical studies have shown that inflation has a definite influence on the exchange rates in the long run. The trend of exchange rates between two currencies has tended to hover around the basic rate discounted for the inflation factor. The actual rates have varied from the trend only by a small margin which is acceptable. However, this is true only where no drastic change in the economy of the country is. New resources found may upset the trend. Also, in the short run, the rates fluctuate widely from the trend set by the inflation rate. These fluctuations are accounted for by causes other than inflation.

2. Differentials in Interest Rates

The interest rate has a great influence on the short – term movement of capital. When the interest rate at a centre rises, it attracts short term funds from other centers. This would increase the demand for the currency at the centre and hence its value. Rising of interest rate maybe adopted by a country due to tight money conditions or as a deliberate attempt to attract foreign investment. Whatever be the intention, the effect of an increase in interest rate is to strengthen the currency of the country through larger inflow of investment and reduction in the outflow of investments by the residents of the country.

Interest Rates: An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. In this respect the growing integration of financial markets of major countries, the revolution in telecommunication facilities, the growth of specialised asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign trading as profit centres per se and the tremendous scope for bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate volatility. Kenya intrinsically has a very weak economy but the rates offered within the country have always been very high. To illustrate this point the treasury bill rate in September 1998 was as high as 23%. High interest rates attract speculative capital moves so the announcements made by the Federal Reserve on interest rates are usually eagerly awaited -an increase in the same will cause an inflow of foreign currency and the strengthening of the US dollar.

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.

3. Current-Account Deficits

Current Account or Balance of Payments, represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exports, both visible and invisible, represent the supply side for foreign exchange. Imports, visible and invisible, create demand for foreign exchange. Put differently, export from the country creates demand for the currency of the country in the foreign exchange market. The exporters would offer to the market the foreign currencies they have acquired and demand in exchange the local currency. Conversely, imports into the country will increase the supply of the currency of the country in the foreign exchange market.

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

As mentioned earlier, a net inflow of foreign currency tends to strengthen the home currency vis-a-vis other currencies. This is because the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the balance of payments. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger.

When the balance of payments of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore, its value in the market declines. If the balance of payments is surplus continuously it shows that the demand for the currency in the exchange market is higher than its supply therefore the currency gains in value.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt courage’s inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

The relationship between government debt obligations and its exchange rate is not as cut-and-dried. Basically, government borrowing to finance deficit spending increases inflation, which literally eats into the value of that nation’s currency. In addition, if lenders believe there is any risk of default, they may sell the debt (in the United States, this debt takes the form of treasury securities) on the open market, exerting downward pressure on the exchange rate.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country’s debt rating (as determined by Moody’s or Standard & Poor’s, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country’s exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country’s currency (and an increase in the currency’s value). If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.

6. Political Stability

Political stability induced confidence in the investors and encourages capital inflow into the country. This has the effect of strengthening the currency of the country. On the other hand, where the political situation in the country is unstable, it makes the investors withdraw their investments. The outflow of capital from the country would weaken the currency. Any news about change in the government or political leadership or about the policies of the government would also have the effect of temporarily throwing out of gear the smooth functioning of exchange rate mechanism.

On the other hand, foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

Conclusion

Aside from factors such as inflation, the exchange rate is one of the most important determinants of a country’s relative level of economic health. A higher currency makes a country’s exports more expensive and imports cheaper in foreign markets; a lower currency makes a country’s exports cheaper and its imports more expensive in foreign markets.

A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed.

Current-Account Deficits, The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. For this reason, the country’s debt rating is a crucial determinant of its exchange rate.

Investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.