Factors that Influence Foreign Exchange Rates

The foreign exchange rate of a currency can be seen as the price of that currency as valued in other currencies. There are generally two rates – one for selling and one for buying that currency. 

The majority of currencies are determined by the free market although there are exceptions where currencies are exchanged at a fixed rate against the US dollar or another currency. Examples of fixed currencies include China (which recently allowed market forces to play a greater part) and Zimbabwe which has pegged its currency to the US dollar to avoid total economic disaster. 

Most currencies float against others. That means that they are determined entirely by market forces. In other words, it is the perceptions of the foreign exchange traders that determines the value. In one sense at least, the value of a currency can be seen as a country’s share price. A strong US dollar generally reflects a strong US economy. A weak British pound may reflect a poor perception of the British economy by the international community.

There has been a limited move towards regional rather than national currencies as illustrated by the Euro. The Euro has almost universally replaced the national currencies of the EU members, and therefore reflects the value of the region as a whole. Recent events have demonstrated that problems in just one member nation can lower the value of the currency.

Currency speculators are able to manipulate the foreign exchange rate of a currency simply because they are able to buy and sell vast quantities of a currency, but evidence of currency manipulations are relatively rare. 

The perceptions of foreign exchange traders are driven by real economic data. These include: 

–  Price parity

–  A nation’s (or region’s) current account 

–  The performance of the economy of a country or a region against other nations

–  The domestic rate of interest

The price parity model is based upon the Adam Smith’s invisible hand theory. Market forces will always drive prices towards an equilibrium. The price parity theory is that over the long run, the price of a currency will adjust itself towardsd achieving that equilibrium level where the price of a basket of goods in one country or region will be on a par with a similar basket of goods in another country, Thus if the US has a 2% level of domestic inflation while Canada has 4% inflation, then the value of the Canadian currency will fall against the US currency to reflect this. 

The current account is the balance between the value of imports and exports. When the value of imports exceeds the value of exports, the current account is in deficit. The current account is in surplus when the reverse is true. A current account deficit means that we are buying more than we can afford and need more foreign currency to pay for it. A surplus means that we are exporting more than we are importing and therefore need more domestic currency. The result (in theory, at least) is that the exchange rate will automatically adjust itself to provide bring the current account back to equilibrium. 

In late 2010, emerging economies have experience a strengthening of their currencies against those of the developed world. The reason is simply that the financial crisis did not impact the emerging economies as much as the world’s biggest economies. Investors see an investment in South Africa as being safer than an investment in the UK. This is based on the economic indicators of the two countries as well as on perceptions. If the economy of country A is perceived to be stronger than that of country B, then the currency of country A will rise against that of country B. 

Interest rates can play a part in influencing the rate of exchange. A 6% rate of interest in South Africa against a 1% rate elsewhere could act as a major South African draw-card for investors. As funds flow into South Africa, the price of the rand increases. 

It is difficult to single out a single factor as a determinant of the rate of exchange. Politics and international perceptions of a country can have a major impact on the value of that country’s currency. The recent recession had a devastating effect on Western economies. Many investors are not looking elsewhere. Many of these factors are interdependent. As with much in economics, a lot seems to be dependent on the perceptions if investors. these perceptions are influenced by a whole range of factors, some real and some imaginary. In either case, the effect is exactly the same.