Factors affecting currency exchange rate
Currency exchange rate is affected by many factors, both, hidden and obvious, direct and indirect. Some people cannot understand why exchange rate of the national currency varies, even in case of the positive economic situation in the country. Why the currency can first go up and then sharply go down. Some factors have long-term effect on the exchange rate, determining movement direction of the currency for many months; others can cause only short-term changes.
We can subdivide factors affecting currency exchange rate according to several criteria:
- Origin of the factor;
- Effect of surprise;
- Impact on the market.
Factors origin can be subdivided into:
- economic factors (they emerge regularly on the basis of economic reports, outcome of the meetings of the Central Banks, speeches by Ministers of Economy and Finance);
- political factors (can be both regular and force majeure);
- natural and anthropogenic factors (always force majeure);
- rumors (emerge on a regular basis).
Duration of the effect can be long-term, medium-term and short-term. Effect on the market can be strong, average and minor.
Economic factors have strong and long-term impact on the market, since exchange rate depends on:
- the state of the country’s economy and the position of the country in the world economic system;
- inflation rate in the country;
- interest rate;
- trade balance;
- the size of the government debt;
- activity in the financial markets (currency, stock or futures);
- monetary policy of the Central Bank.
The results of the negotiations, speeches of heads of state and financial institutions, situation in the oil and gas sector, or in the commodity market, speculation in the foreign exchange market can also influence on the currency exchange rate.
General state of the country’s economy determines movement direction of the currency because it helps investors and trade partners evaluate prospects of future cooperation with the government enterprises and agencies and possibility of obtaining profit.
For example, in a country with a steadily increasing yield, low inflation, high interest rate, we can expect inflow of foreign currency.
Country's position in the world economic system can increase demand for the national currency. The most striking example is the USD – despite numerous contradictions and imbalances in the American economy, demand for the USD is growing, enabling the country to refinance its public debt. One of the reasons of such situation is the role of the USD as a reserve currency and the currency of international payments. Note that, Norway and Iran refused to use the USD for making international payments and started to use Euro instead. There were cases in the world history when a currency has lost its role as the currency of international payment system: at the beginning of the 20th century, the pound sterling played a leading role in the global economy, but gradually it has lost its status.
Inflation rate and the level of the interest rate are closely related and together these two factors greatly affect the exchange rate of the national currency. Firstly, the rise in inflation indicates evolving problems. Secondly, inflation growth forces the Central Banks to increase interest rates in order to curb inflation.
- In a country with the low inflation rate, the price of the national currency is increasing. For example, the price of the pair EUR/USD declines each time when index of consumer prices falls below the forecast.
- The rise in the interest rate in a country with high inflation will increase the price of the national currency, so attempts of the European Central Bank to stop depreciation of the Euro always lead to the rise in price of the pair EUR/USD.
However, there are always exceptions to the rules. In Japan depreciation of the national currency always takes place amid low rate of refinancing.
Trade balance of the country shows how much money
the country spends for buying foreign goods and how much
money it receives from selling nations products. Turnover of the
country strongly affects exchange rate of the national currency.
Country's public debt may be expressed in the national currency, if the money is borrowed in the country or in a foreign currency, if the government uses the funds of the international reserves or the currency of the other countries. Large national debt involves interest payment, so sometimes foreign currency is purchased in the international markets for this purpose. Quarterly interest payment increases pressure on the national currency and leads to the decline in the rate of the national currency.
High activity in the financial markets of some countries with the high interest rates often attracts foreign investors from the developed countries who do not see potential for gaining profit in their national market. Inflow of the investment funds affects exchange rate of the national currency.
Monetary policy of the country is a factor, which deserves special attention. For example, the second largest economy in the world after the United States uses fixed exchange rate, despite the fact that many investors would like to invest into China. This is the most striking exception from the system of floating exchange rates that was established after Bretton Woods.
Monetary policy determines:
- degree of government intervention into the currency market: the rise in the national currency makes domestic goods uncompetitive in the world market, which often leads to the intentional devaluation of the exchange rate;;
- frequency and volume of intervention to the foreign exchange market: the Bank of Japan often throws billions of the USD to the market aiming to temporary stabilize exchange rate of the national currency;
Political factors affecting currency exchange rate
Although exchange rate of the currency is determined by economic factors, political factors also have strong impact on the currency movement. Appointment of a new minister, election of a President, protests and political meetings can influence on the investors’ decisions.
The effect of the political factor will depend on:
- its impact on the economy: for example, election of a new President.
- Power of influence on the country’s stability: Political earthquakes can have significant and long-term effect on the currency movement.
- Effect of surprise: markets actively react to the unexpected news inside the country. Investors can overestimate possible damage, and volatility in the market can increase.
- Duration of the effect: protracted Russian-Ukrainian conflict causes decline in the Russian currency, which has been lasting for 2 years.
Political factors also include investor confidence to the national currency. In order to evaluation confidence, we should know what currency people prefer for keeping their savings, the level of capital outflow and the speed of payment settlements with the non-residents. The trust of foreign partners to the country’s government determines investment climate in the country and the volume private capital flow.
Other factors affecting currency exchange rate
Rumors can also affect currency movement. Usually, rumors have only short-term impact on the currency. Rumors can touch any significant economic event. As a rule, only individual investors pay attention for the rumors; and therefore, they do not have strong effect on the currency movement. Rumors constantly emerge in the currency market, so most of the traders eventually stop paying attention to them.
Natural and anthropogenic factors such as hurricanes, earthquakes, nuclear accidents and terrorist attacks are unpredictable and raise panic in the markets. Investors, who try to use these factors for making profit, usually lose their money. Experienced traders prefer to refrain from operations in case of such situation.