Factors that Influence Exchange Rates

Aside from factors such as "interest rates" and "inflation", the "exchange rate"  is one of the most significant determinants of a country's relative level of  economic health. It play a vital role in a country's level of trade, which is  critical to most every free market economy in the world.

Major Forces Behind Exchange Rate Movements:

A higher currency makes a country's exports more expensive and imports cheaper  in foreign markets; a lower currency makes a country's exports cheaper and its  imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate  would increase it.

Determinants of Exchange Rates: Exchange rates are relative, and are expressed as a comparison of the currencies of two countries.

(i) Inflation: As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

(ii) Interest Rates: By manipulating interest rates, Central Banks exert  influence over both inflation and exchange rates, and changing interest rates  impact inflation and currency values. Therefore, higher interest rates attract  foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.

(iii) Deficits of Current Account: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

(iv) Public Debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real currency in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

(v) Terms of Trade: A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value).

(vi) Political Stability and Economic Performance: Political turmoil can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

Inference: The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities.