Exchange rates – a generic term that often pops up in financial news and economic forecasts, casting an overwhelming shadow on the layperson’s understanding. The gyrations they undergo influence everything from the price of your holiday abroad to the health of global economies.
But what determines these fluctuations? In this article, I will take you on an exploration of the forces that stir the seas of international finance.
With the help of clear and relatable examples, I will break down the factors that influence these rates—from macroeconomic indicators and interest rates to international trade and political stability, to provide you with comprehensive insights.
1. Economic Performance
Economic indicators can significantly impact exchange rates. For instance, high inflation rates can depreciate a currency’s value, while lower inflation rates typically strengthen it. The purchasing power of a particular currency decreases with high inflation. As a result, its exchange rate tends to weaken.
Interest rates also play a crucial role. When a country’s central bank raises interest rates, it can attract foreign investors seeking higher returns, thereby increasing demand for that currency and causing its value to rise.
Conversely, lower interest rates can lead to a depreciation of the currency.
Another economic factor is the balance of trade, which is the difference between a country’s exports and imports. A trade surplus (when exports exceed imports) can cause a currency’s value to rise, while a trade deficit can cause it to fall.
Lastly, economic growth indicators, such as Gross Domestic Product (GDP), employment levels, and retail sales data, also influence exchange rates. Robust economic growth usually strengthens a currency, while a slowdown or recession can weaken it.
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Example – The Zimbabwean economy experienced an extreme case of hyperinflation from the late 1990s to 2009. At its peak, Zimbabwe’s inflation rate reached an astronomical 89.7 sextillion per cent per month. The result was a severe depreciation of the Zimbabwean dollar, which eventually led the government to abandon the local currency in favor of the US dollar.
2. Political Stability and Economic Policy
Political stability is paramount in maintaining a strong currency. Countries with less risk of political turmoil tend to have stronger currencies because they offer safer environments for foreign investors.
Changes in government or economic policy can significantly affect a currency’s value. For example, the implementation of capital controls (restrictions on the flow of currencies) can reduce the desirability of a currency, lowering its value.
On the contrary, free-market reforms or policies promoting economic liberalisation generally tend to strengthen a currency.
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Example – When the UK voted to leave the European Union (EU) in 2016, the uncertainty around the country’s political and economic future led to a significant depreciation of the British pound. This event demonstrated how political changes can dramatically impact a country’s exchange rate.
3. Market Psychology and Speculation
Market psychology and speculative trading can have substantial effects on exchange rates. If traders believe a currency will rise in value, they will increase their demand for it, driving up its value. If they think the currency will depreciate, they will sell it, causing its value to drop.
News events often drive these perceptions. For instance, news about political instability, changes in economic policy, or the release of economic data can lead traders to buy or sell currencies.
Therefore, the foreign exchange market is susceptible to short-term fluctuations.
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Example – Billionaire investor George Soros famously “broke the Bank of England” in 1992 by speculating that the British pound was overvalued. His actions led to a massive sell-off of the pound, causing its value to plummet. This event shows how speculative trading can have a significant impact on exchange rates.
4. Natural Disasters and Pandemics
Unexpected events such as natural disasters or pandemics can affect a country’s economy and, in turn, its currency.
These events can disrupt a nation’s infrastructure, hinder productivity, and increase government spending, which can lead to currency depreciation.
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Example – The devastating earthquake and tsunami in Japan, followed by the Fukushima nuclear disaster in 2011, led to a sharp depreciation of the yen. The disasters caused massive destruction and loss of life, leading to a decline in investor confidence and a decrease in the value of the yen.
5. Global Events and International Relations
Global events and relations between countries can significantly affect exchange rates. For example, a war or conflict can negatively impact the currency of the involved nations due to the uncertainty and economic instability it causes. Similarly, sanctions or embargos can also lead to currency depreciation.
On a positive note, strong relations between countries can enhance trade, fostering economic growth and currency appreciation.
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Example – The trade war between the U.S. and China, characterised by both countries imposing tariffs on each other’s goods, created significant uncertainty in global markets. This tension led to fluctuations in both the U.S. dollar and the Chinese yuan