Factors influencing exchange rates

Foreign exchange rates are extremely volatile and it is incumbent on those involved with foreign exchange – either as a purchaser, seller, speculator or institution – to know what causes rates to move.

Actually, there are a variety of factors – market sentiment, the state of the economy, government policy, demand and supply and a host of others.

The more important factors that influence exchange rates are discussed below:

  • Strength of the Economy :The strength of the economy affects the demand and supply of foreign currency. If an economy is growing fast and is strong it will attract foreign currency thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign currency far outstrips the outflow of their own currency. The result is usually a strengthening in its value.
  • Political and Psychological Factors: Political or psychological factors are believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way such as Swiss francs which are known as a refuge or safe haven currency while the dollar moves (either up or down) whenever there is a political crisis anywhere in the world. Exchange rates can also fluctuate if there is a change in government. Some time back, India’s foreign exchange rating was downgraded because of political instability and consequently, the external value of the rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened.
  • Economic Expectations :Exchange rates move on economic expectations. After the 1999 budget in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations affect the external value of the rupee, all economic data – the balance of payments, export growth, inflation rates and the likes – are analysed and its likely effect on exchange rates is examined. If the economic downturn is not as bad as anticipated the rate can even appreciate. The movement really depends on the “market sentiment” – the mood of the market – and how much the market has reacted or discounted the anticipated/expected information.
  • Inflation Rates : It is widely held that exchange rates move in the direction required to compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e. stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that an exchange rate is a relative price and hence the market weighs all the relative factors in relative terms (in relation to the counterpart countries). The underlying reasoning behind this conviction is that a relatively high rate of inflation reduces a country’s competitiveness and weakens its ability to sell in international markets. This situation, in turn, will weaken the domestic currency by reducing the demand or expected demand for it and increasing the demand or expected demand for the foreign currency (increase in the supply of domestic currency and decrease in the supply of foreign currency).
  • Capital Movements : Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons – both positive and negative. When India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the country weakening the currency. These were capital outflows. One of the reasons popularly believed for the rupee not depreciating in the manner other South-east Asian currencies did in 1997-98 was because the rupee was not convertible on the “capital account”.
  • Speculation : Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Kenya shilling. The most famous speculator in foreign currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly predicting the devaluation of the pound) and then is believed to have triggered the free fall of the currencies of South-east Asia.
  • . Balance of Payments : As mentioned earlier, a net inflow of foreign currency tends to strengthen the home currency vis-à-vis other currencies. This is because the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the balance of payments. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger.
  • Government’s Monetary and Fiscal Policies : Governments, through their monetary and fiscal policies affect international trade, the trade balance and the supply and demand for a currency. Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will slow economic growth and this will reduce demand for imports and encourage exports. The effectiveness of the policy depends on the price and income elasticities of demand for the particular goods. High price elasticity of demand means the volume of a good is sensitive to a change in price. Monetary and fiscal policy support the currency through a reduction in inflation. These also affect exchange rate through the capital account. Net capital inflows supply direct support for the exchange rate. Central governments control monetary supply and they are expected to ensure that the government’s monetary policy is followed. To this extent they could increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation, restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into the country is offering very high rates on its treasury bills. In order to maintain exchange rates at a certain price the central bank will also intervene either by buying foreign currency (when there is an excess in the supply of foreign exchange) and selling foreign currency (when demand for foreign exchange exceeds supply). This is known as ‘central bank intervention’. It must be noted that the objective of monetary policy is to maintain stability and economic growth and central banks are expected to – by increasing/decreasing money supply, raising/lowering interest rates or by open market operations – maintain stability.
  • Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small measure, by expectation of change in regulations relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market. As explained before, intervention is the buying or selling of foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur.
  • Interest Rates : An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. In this respect the growing integration of financial markets of major countries, the revolution in telecommunication facilities, the growth of specialised asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign trading as profit centres per se and the tremendous scope for bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate volatility.  Kenya intrinsically has a very weak economy but the rates offered within the country have always been very high. To illustrate this point the treasury bill rate in September 1998 was as high as 23%. High interest rates attract speculative capital moves so the announcements made by the Federal Reserve on interest rates are usually eagerly awaited – an increase in the same will cause an inflow of foreign currency and the strengthening of the US dollar.
  • Tariffs and Quotas : Tariffs and quotas exist to protect a country’s foreign exchange by reducing demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports. Very few items were permitted to be freely imported. Additionally, high customs duties were imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not popular internationally as they tend to close markets. When India lifted its barriers, several industries such as the mini steel and the scrap metal industries collapsed (imported scrap became cheaper than the domestic one). Quotas are not restricted to developing countries. The United States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese goods.
  • Exchange Control : The purpose of exchange control is to manage the supply and demand balance of the home currency by the government using direct controls basically to protect it. Currency control is the restriction of using or availing of foreign currency at home/abroad.

In India, up to liberalization in the nineties there was very severe exchange control. Access to foreign currency was tightly controlled and the same was released only for permitted purposes. This was because Indian exports had not taken off and there were still large imports. There are several countries that maintain their rates at artificial levels such as Bangladesh.

India is now fully, convertible on the current account but not as yet on the capital account. This, to an extent, possibly saved India when the run on currencies took place in Asia in 1997. If the Indian rupee was fully convertible and there were no exchange control restrictions, the rupee would have been open for speculation. There would have been large outflows at a time of concern resulting in a snowballing plunge in its value.

As long as the par value system prevailed, the rates could not go beyond the upper and lower intervention points. The only real question under the fixed rate system was whether the balance of payments and foreign exchange reserves had deteriorated to such an extent that devaluation was imminent or possible. Countries with strong balance of payments and reserve positions were hardly called upon to revalue their currencies. Hence, a watch had to be kept only on deficit countries. However, under generalized floating regime, exchange rates are influenced by a multitude of economic, financial, political and psychological factors. But the relative significance of any of these factors can vary from time to time making it difficult to predict precisely how any single factor will influence the rates and by how much.

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