The global economy is interlinked by trade. While there are only a few currencies that get the largest share of trade volume, almost all currencies in the world are traded at foreign exchanges. This is because a constant flow of currencies is necessary for smooth trade.
The exchange rate of a particular currency is an important determinant of the economic health of the country. Countries that have strong currencies are also most likely to have strong credit levels and strong trading levels.
There are many factors that affect the foreign exchange rates. The following is an examination of the seven key factors that affect forex rates.
Interest rates can cause the exchange rates of a currency to increase or fall. Interest rates work in tandem with the inflation. Forex rates are affected by interest rates because of demand. When interest rates change, the level of lending and borrowing is affected. Lending, in turn, determines if the country will be able to attract foreign capital. If the change in interest rates lead to a bigger inflow of foreign capital, then the exchange rate of the local currency goes high.
Inflation is also correlated to interest rates. Inflation is the general increase in the price of commodities in the market. The forex market responds to the change in prices in the market indirectly.
The increase in price levels affects the demand for goods negatively. When goods are not being demanded in huge volumes, the value of the currency decreases and this leads to its low demand at the foreign exchange market. A lower inflation is thus necessary for the increase in the value of the local currency.
Balance of Payments
The balance of payments is also known as the current account. The current account is the overall computation of a country’s relative performance in terms of trade when compared to other countries. In order to compute the balance of payments, the total number of exports, debts, imports and other economic factors are calculated.
A country that has a positive balance of payments after the calculation will also see its currency appreciate while that with a negative current account will see its currency depreciate.
The debt by a government can determine its level of borrowing. If a country already has a huge debt, additional borrowing becomes a challenge. With foreign capital not flowing into the country, a high inflation ensues. This, in turn, leads to the depreciation of the local currency.
The level of trust in the government by foreign investors also goes low when there is a huge national debt. The national debt is thus a major factor for determining the exchange rate of a currency.
The political situation in a country is also important when it comes to determining the exchange rate. Investors always look to invest in places where the security of their assets is guaranteed.
Countries with a lot of political instability are thus less likely to attract foreign investment. Since foreign investment comes with an inflow of foreign currency, the lack of it means that the local currency will be of less value in the foreign exchange market.
A country that is attracting large amounts of FDI will also see its currency attract a strong exchange rate.
Terms of Trade
The terms of trade also influence the exchange rate of a particular currency. The terms of trade are somehow related to the balance of payments. While the balance of payments is the general difference in the level of inflow and outflow of commodities, the terms of trade specifically refer to the ratio of export prices to import prices.
When this ratio is high, there is a general higher demand for local currency and this strengthens it in the forex market. A lower ratio also has the opposite effect.
A recession has far-reaching effects for the economy of a country as a whole. The first area of the economy that is affected is the realm of interest rates. When the interest rates fall, the country becomes less inclined to acquire foreign capital. This, in turn, results in a lessened supply of foreign currency.
The results of this are a less attractive local currency at the exchange market. The exchange rate of the local currency thus goes low to respond to the low demand.