Foreign Exchange and Factors Affecting Foreign Exchange Rates

Foreign Exchange and Factors Affecting Foreign Exchange Rates

Before discussing about the factors affecting the Foreign exchange, we have to understand the concepts of foreign exchange.

Factors Affecting Exchange Rates

In the era of Globalization and International trade foreign exchange plays a vital role in determining the health of economy and relative strength compared to other economy. In simple words we can define exchange rate as “The rate at with the currency of one county can be converted to another country at that time.” 

Let one product available in USA market with MRP of $ 50 and you need that product in India then think how much you have to pay? At this time the foreign exchange rate plays the key role in determining the amount payable in INR.  If the remitting organization says u the exchange rate of USD-INR is 72.50, it means $ 1 = ₹ 72.50. Then you have to pay ₹ 3625/- excluding brokerage charges to the organization.  Suppose in another day you wish to import the same item again and you visit the remitting organization, they say today American Dollar/United States of American  Dollar (USD) rate is   $76.00 then you have to pay ₹3800/- for the same product . 

Then ultimate question comes to our mind why? Why should I pay more money for the same product with same MRP.

Answer to this question is the exchange rate of the currency has changeed in between your transactions so this happened. 

The next question in our mind is

Why this exchange rate of currency is changed?

What are the factors that affect the exchange rate of a currency? 

Major Currency 

In this article we are going to discus about few main points that determines the exchange rate of currency of any country. The key factors of fluctuation in currency exchange rate are both internal and external to the economy of that country.

1: Balance of Payments (BOP)/Country’s Current Account: The balance of payment is the inflow of money to the country compared to outflow of money. The current account of a country that account which keeps all the records export, import and external debt etc. In simple words it is account which keeps records of all transaction with outside economy/countries. If a country is more dependant on exports of goods and service then its currency may devaluate in compared to that country. Suppose in India we import Gold, Petroleum product from other countries and paying in USD $ then our currency will devaluate as compared to Dollar. More import than Export leads to currency devaluation and less import high export results in currency appreciation.

2.  Rate of Inflation: A country with low rate of Inflation compared to other country; the currency will appreciate with respect to that county and vice versa. A country with continuous fall in inflation leads to currency appreciation and with continuous rise in inflation will result in currency devaluation.

3. Interest Rate: The interest rate is directly correlated with the foreign exchange. Higher the interests rate higher the inflow of money from abroad results in currency appreciation.  If the rate of interest is low money will go out  resulting depreciation of currency.

4. FII & FDI: FII stands for Foreign Institutional Investor and FDI stands for Foreign Direct Investment. When stock market of a county looks undervalued and the international fund managers fell then can get better  return they invest in that country . This creates demand for currency of that particular country hence currency of that country appreciate and vice versa. Similarly if the Multinational Corporate invests in the growth story of economy of particular country then currency of that country gets appreciated.

5. National Debt: National Debt is the debt taken by government and owned by the Government. When the Government has taken excess debt there is very less chances that there will more debt by the Government, subsequently there will rise in inflation. This will force the foreign investor to sell their bonds and money gets out of economy resulting deprecation of the currency.

6.Recession: The country’s economy is in recession means definitely the interest rate will fall and the economy will lose its ability to attract the foreign investment. This wills leads to currency devaluation compared to the currency of developed world currency like United Kingdom’s Pound, United State’s Dollar and Japanese’s yen.

7.Political Situation:  Political situation is one of the major determinants of the currency exchange rate. Higher the instability of the politically situation like war, hang government, national emergency, military coup then Currency of the county will devaluate. If the political situation is stable this will increase faith of foreign investor and they will help in appreciation of currency.

8.Terms of Trade: The terms of trade are the ratio of export prices to import prices. If the country’s export prices increases with greater rate than its import price then it leads to higher revenues. Higher revenue is directly linked to demand for countries currency and subsequently its appreciation.

9.Speculation:  Sometimes the currency trader confirm that the value of particular country’s currency will increase then they hold buying position in the currency and its derivatives, this leads to rise in value of currency. Likewise when they confirm the currency is going to devaluate then they initiate short position in currency through derivative leading to decrease in demand for that currency, this leads to further devaluation of currency.

10.Economic Development:  When the economy of country shows growth regularly then the currency of the county gets appreciated in comparison to the other developed counties currency and vice versa. This is the prime factor for long term currency appreciation.

All the above ten factors are the main reasons which affect Foreign Exchange Rates , few of them have long term impact and few of them have short term impact in currency evaluation . The USD $ treated as universal currency in the world because this currency can be exchanged with all currency of the world economies. Here is the list of all international currency and its exchange rate with the USD $. The impact of currency appreciation and devaluation has different impact on economy as a whole and also on individual sector which we will discuss in a different article.