Factors That Influence Exchange Rates
The exchange rate can be affected by any political or economic disturbance. The exchange rate is the reflection of the financial health of a country or region. The main factors that influence the exchange rate are well known, and most of the time they can be anticipated after doing a fundamental analysis of the country monetary policy and their economic reports. Traders need to review the country financial projections and follow the most important political news to have an edge on the exchange rate anticipation.
1. Macroeconomic changes on the Monetary Policy
It is one of the most important factors that influence exchange rates. The country’s government or its Central Bank can make adjustment or changes to the exchange rate to solve fiscal problems. Any change in the country’s exchange rate will affect the currency exchange rate immediately.
a) Devaluation a country can decrease his currency value or increases its exchange rate to attract more foreign inversion making it cheaper for the international market. Most of the time significant devaluations are only seen on exotic currencies with strong market controls from their governments. Additionally, devaluation is viewed in countries with expansive monetary policy, which tries to become more competitive and reduce the production cost for international investors in an effort to increase its employment and manufacturer industries. Most of the time this measure is anticipated by risk agencies allowing traders and large note holders to get ready for its implementation.
b) Revaluation a country can increase his currency value or lower its exchange rate to promote national production or to protect its currency value. This measure is uncommon and usually is secondary to some international pressure to alleviate the trade deficits between two countries.
c) International reserve changes. The international reserve is the country funds or assets, which backed the country currency. It can be exchanged among different countries or central bank. When a country decreases its international reserve, it investment risk increases. Therefore, the currency value falls, or it is devaluated. On the other hand, after a remarkable increase in the country’s international reserves, the country’s currency value increases.
d) Exchange control is the set of an exchange rate determined by the government without the free-floating exchange market participation. Some countries have a fixed exchange rate for its currencies, and they manipulate it as its entire convenience.
2. Social or political stability
An investor needs some guaranteed for its assets and the ability to repatriate its profits. For this reasons, any possible alteration or instability in the country regular peace will decrease their interest buying the national currency or its interest about investment in a particular country. Therefore, notes holder will try to sell their participations increasing the exchange rate. Moreover, traders will avoid the higher risk currencies which price can drop too fast. As a result, the global market demand will decrease sharply. On the other hand, the opposite scenario will open the country’s financial system for the foreign investor. Offering favorable conditions and increasing its national currency value or lower the exchange rate.
3. Market speculations
Any rumor can influence the market leading to sharp changes in the exchange rate. The speculation can also be generated by big traders, who decide to buy or sell enormous amounts of its currency investments creating an increase in the offer or the demand for a particular currency. The alteration in the level of offer or demand produces market distortions, which usually start vicious cycle generation more speculation.
4. Interest rate variation
Modification in the interest rate may be followed by exchange rate fluctuations. The interest rate modification Influence the exchange rate in several ways.
- When the interest rate is increased, it can attract more foreign capital to its banks. Investors are always looking for the best profit for their investment. Therefore, investors will exchange their currency for the one who pays higher interest for deposit and offers a secure return. As a direct consequence of this, the demand for the currency will increase influencing the exchange rate.
- When the interest rate is decreased, some investor lack interest in having a large deposit of the currency and sell it. Additionally, a cheap money supply makes possible to borrow from the bank and exchange it for a foreign currency with better dividends. In both cases, the offer for the currency increases and its value decreases.
5. Country’s inflation rate
The inflation rate is a trigger for exchange rate increases. When the inflation rate is high or becomes unpredictable for the year or the month; the country inhabitants and investor try to sell the currency. The inflation itself influences the exchange rate to be lower for the national currency, making more expensive to buy any major currency. This scenario is typical in distress’ economies such as third world countries where prices vary from day to day. It produces that investor lack interest in keeping deposits in the country, increasing the price of any foreign currency. This scenario can be seen in the Venezuela currency (BsF). In one week, the exchange rate can increase in more than 50%.
6. Government Debt
The government debt level is used as an investment risk calculator. When the government debt increases, the value of its bonds decreases, as a direct consequence of a significant risk perception for the country to be unable to pay its obligation and an imminent default. This increased risk makes investors to withdraw is capital to a safer place. Furthermore, once the government debt is higher than 40% of its GDP, the devaluation probability increases generating that the offer of the currency increases substantially from all traders, investors, and inhabitants of the county, who wants to save their capital.
Several factors influence the exchange rate, investors and traders require a high level of trust on the country economy to buy its currency and hold it over time. The rumors or fears can produce that the exchange rate is skyrocketing and the national currency lost its value to unpredictable levels. The country monetary policy has an immediate influence on the exchange rates. The offer and demands are the kings of the forex market, and it’s responsible for the exchange rate on floating currencies. In a nutshell, anything that influences the market will influence the exchange rate.