In this article we will talk about what the currency rate is, and also consider what the currency rate depends on, i.e. what factors influence the exchange rate.
What is the currency rate?
Before proceeding to consider the question of what the exchange rate depends on, let s first understand what a currency rate is.
Currency rate or exchange rate (English Exchange Rate) is the price of a national currency expressed in the currency of another country. This price is formed in the foreign exchange market under the influence of supply and demand, which in turn depend on a number of exchange rate-forming factors.
The exchange rate is the price that is set in the national currency per unit of foreign currency and is determined by the ratio between the national currency and the corresponding foreign currency, based primarily on their purchasing power. In economics, there is such a concept as purchasing power parity, which is usually formulated using the so-called law of one price: the price of a good in one country must be equal to the price of a good in another country; and since these prices are expressed in different currencies, it is this price ratio that determines the exchange rate of one currency for another.
There are several types of exchange rates: official, market, exchange, buyer s rate, seller s rate, exchange rate, and the like.
There are two main exchange rate regimes:
- Fixed – the exchange rate is set as a fixed value for a certain period of time.
- Floating – the exchange rate, which is formed exclusively under the influence of market factors, i.e. the state (represented by the central bank and the government) does not take any action to influence the exchange rate.
Factors that influence the exchange rate
The exchange rate depends on a number of factors. In this section, we will look at the main ones.
Country balance of payments
The basis of the country s balance of payments is the foreign trade balance, which is the ratio between the volume of exports and imports of goods, works, services. Due to exports, an inflow of foreign currency is carried out, due to imports, an outflow occurs. A positive trade balance indicates an excess of exports over imports, respectively, a surplus of foreign currency appears in the country, which contributes to the strengthening of the national currency. A negative trade balance has the opposite effect – there is a deficit of foreign currency, which leads to a weakening of the national currency.
The country s balance of payments includes the foreign trade balance, as well as other foreign economic cash flows, in particular the inflow and outflow of investments, external borrowings, payments of migrants, payment-receipt of income in the form of dividends, interest on loans, etc. As in the trade balance, the positive balance of payments has a strengthening effect on the exchange rate of the national currency, while the negative balance has a weakening effect.
It should be noted that the negative balance of trade can be “leveled” by the balance of payments – for example, due to the inflow of foreign investments or external borrowings.
Macroeconomic indicators of the country
The key macroeconomic indicator of a country that affects the exchange rate is inflation rate… Since the exchange rate is based on purchasing power parity, then, accordingly, a higher inflation rate in a country leads to a decrease in the purchasing power of money and leads to a fall in the exchange rate in relation to countries where inflation rates are lower. The dependence of the exchange rate on the rate of inflation is especially high for countries with a high share of foreign economic activity. Therefore, when analyzing the exchange rate, great importance is attached to such indicators as the consumer price index and the producer price index.
GDP dynamics… GDP growth is a positive indicator for the exchange rate, since can contribute to the inflow of foreign investment into the country, reduce inflation, etc. At the same time, the fall in GDP, as a rule, has the opposite effect.
Balancing the state budget… The budget deficit, especially if the source of its coverage is the additional emission of money supply, leads to an increase in inflation and, as a consequence, to a decrease in the exchange rate.
Government debt level… A high level of public debt, especially if external borrowings were used, creates an additional burden on the country s balance of payments, because in addition to the main debt, it is also necessary to service it – i.e. pay interest. During periods of significant debt payments, excessive demand for foreign currency is generated, which leads to a depreciation of the national currency. It should also be borne in mind that a high level of public debt has a negative impact on the country s credit rating, which entails an increase in the risk of default and, as a consequence, an increase in the cost of attracted resources.
Monetary policy implemented by the country s central bank is one of the key factors influencing the exchange rate.
Foreign exchange intervention… In order to smooth out sharp jumps in the national currency rate, the central bank conducts operations in the open foreign exchange market: it sells or buys foreign currency to balance supply and demand, which helps to maintain the national currency rate at a certain level or in the range of the so-called “currency band”. Foreign exchange interventions have a short-term effect.
Interest rate level… The central bank s discount rate is an indicator of the cost of resources in a country. On the one hand, low interest rates make loans more affordable for businesses and the population, which contributes to the growth of lending, increased consumption, GDP growth, lower inflation and, as a consequence, the strengthening of the national currency. But on the other hand, lowering interest rates makes the inflow of foreign capital less attractive, and also contributes to the outflow of national capital to countries where the level of interest rates is higher. Therefore, such a movement of capital (especially speculative “hot” money), increases the volatility of the balance of payments.
Regulation of export-import operations… The central bank (sometimes in conjunction with the country s government) sets the rules for foreign exchange regulation and control. The central bank can establish restrictions on the conduct of certain operations, establish special rules for the purchase and sale of currency. For example, during a period of severe deficit, the central bank may impose a mandatory sale of export earnings or raise its rate. Similar actions are used by the central banks of countries with non-convertible currencies.
Money issue… If the additional emission of money exceeds the needs of the economy (GDP growth), then, other things being equal, such emission will lead to inflation and a weakening of the national currency.
Financial and political stability in the country
The exchange rate is very sensitive to any destabilizing factors in the country:
- deterioration of the investment climate;
- frequent changes in legislation in the field of business regulation, currency control, taxation, etc .;
- change of political regime;
- strikes, riots;
- armed conflicts and hostilities;
- violation of the territorial integrity of the country, etc.
The level of confidence in the national currency
Based on the data of the main macroeconomic indicators and taking into account other factors affecting the exchange rate, the population and business have a personal level of confidence in the national currency, on which the further strategy of behavior depends. In particular, during a period of economic and political turmoil, confidence in the national currency falls, which leads to the migration of savings from the national currency to more stable currencies and, as a result, to an even greater weakening of the national currency (see Dollarization of the Economy). And this, in turn, leads to a domino effect, and if the central bank does not take active steps to maintain the exchange rate, then the situation can very quickly get out of control – there is a rush demand, which there is practically nothing to satisfy. In such conditions, the number of speculative transactions increases significantly. A similar situation is typical for countries with developing economies.
The movement of world capital primarily depends on the level of confidence in the currency.
Conclusion… We examined the main factors that put pressure on the exchange rate. Summing up, I would like to note that two or more factors can have both unidirectional and multidirectional effects. For example, falling GDP and political instability will only exacerbate currency depreciation, while the trade deficit can be covered by additional investment inflows into the country. It should be noted that other factors can also influence the exchange rate:
- large-scale natural disasters (tornado, tsunami);
- man-made disasters (accidents at nuclear power plants, etc.) and other environmental risks;
- in Western markets, the influence on the exchange rate is exerted by the speculative actions of various funds (investment, pension, insurance, hedging);
- for the so-called resource-based economies, the primary factor will be the dynamics of prices for exported raw materials (in most cases, oil), etc.