Alroy Commentary - What are the factors that move Exchange Rates?
Exchange rate plays an important role in international trade. If a country’s currency appreciates, exports become more expensive and imports become cheaper. Domestic consumers might switch their expenditure to imported products and away from expensive domestic goods and services. Even we all understood the power of exchange rate, we might not know what are the factors that move exchange rate. Generally speaking, there are six determinants to influence exchange.
1. Differentials in Inflations
High inflation means that domestic goods increase in price quicker than imported goods. Therefore domestic goods become less competitive and demand of them will fall. As a result, there will be less demand of domestic currency. High inflation is likely to decrease currency value.
2. Differentials in Interest Rates
Central Bank adjusts interest rates when the economy grows too fast or too slow. If a country set its interest rate higher than other countries, foreign investors would like to deposit money into the banks in that country as they can earn higher interest incomes. High interest rate is likely to increase currency value.
3. Balance of Trade
Balance of trade measures the import and export of a country. To settle the trade, importers exchange their home currency into foreign currencies to settle the bill. The rising demand of imported goods will generate more demand for the foreign currencies. The currency value is likely to depreciate.
4. Public Debt
Countries with large public deficit and debts are less attractive to foreign investors. A government may print money to pay part of a debt, meanwhile, inflation is a likely result and drives currency down.
5. Terms of Trade
It is a ratio comparing export prices to import prices, it improves if the price of a country exports rises by a greater rate than that of imports. The rising revenues from exports will generate more demand for the country’s currency and the currency value increases.
6. Political Stability and Economic Performance
Investors seek out stable countries with good economic performance and such countries will draw investment funds away from other countries with more political and economic risk. If a country suffer from political turmoil, confidence in a currency will lose and capital move to other currencies of more stable countries.
Impact on Investments
The exchange rate of the currency is one of the important factors that determine portfolio’s real return. A decrease in exchange rate reduces the purchasing power of income and capital gains. However, if home’s currency depreciated against investment currency, investors can generate extra returns from the currency movement. Investors should fully aware the inherent risks of currency movement, or choose the instrument that hedged the risk of exchange rate, in your own investment.
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