What affects foreign currency exchange rates?

There was a joke making the rounds at the time of the credit crisis of 2008 – ‘What’s the difference between Iceland and Ireland? One letter and six months’.

At the time the two islands had a lot in common in that they both experienced spectacular gains in the early 2000s thanks to banks that grew too quick and lent too much. In November 2008, Iceland succumbed to the humiliation of an international bailout. Though it took two years for Ireland to follow suit.

The resemblance ended there though, as by 2012 Iceland’s economy was growing briskly and unemployment had eased to 6%. Ireland was barely growing and unemployment was stuck at 14%.

The most important reason for their divergent paths is that Iceland had it’s own currency, the Krona. During the crisis it’s value plunged, which eventually boosted exports and tourism. It also lead to higher inflation, which reduced the real value of Iceland’s debts, making them easier to repay.

Ireland ditched it’s own currency a decade earlier and adopted the Euro. Without it’s own currency, Ireland couldn’t use inflation to reduce it’s debts or devaluation to boost exports. The differing experiences of Iceland and Ireland illustrated something people didn’t think much about until the euro crisis: why a country’s choice of currency matters to its economic prospects.

What Drives Foreign Exchange Rates

Dollars, euros, yen and pounds lurch about with all the purpose of a toddler in a toy store. Yet there is method to their madness. In the long run, the most important driver of foreign currency exchange rate is inflation. A country that persistently runs higher inflation than its trading partners will see its currency fall as its purchasing power declines.

In the 1970s and 1980s Britain’s inflation was higher than Germany’s and the pound declined against the German Deutsche mark, the foreign currency it used until 2002 when it adopted the Euro.

Suppose Britain and Germany both export similar cars but their prices rise 5% a year in Britain because of higher inflation and just 2% in Germany. Customers will buy fewer British and more German cars. Demand will decline for the British pound and rise for the deutsche mark. Eventually, the pound will fall enough to make British cars as cheap as German cars again.

A related driver of foreign currency is productivity. Suppose Korean workers and managers find a way to make more ships and televisions with the same number of workers. It would soon be able to sell them more cheaply than its competitors.

Korean exporters sales would rise, earning the more dollars, euros, yen and francs. As they exchanged those currencies for won to pay their workers and shareholders, the won would rise. Eventually, its increase would cancel out the cost advantage those exporters had achieved through higher productivity.

These two examples show that between two countries, the one with higher productivity growth and lower inflation should have the stronger foreign currency.
If that were the whole story then big current account deficits and surpluses should not persist because it’s not just the flow of goods and services that determines the exchange rates, it’s flow of capital as well.

A country must finance a current account deficit by selling assets such as stocks, companies, land or by borrowing (i.e. issuing bonds). If its assets are in big demand, its foreign currency will remain strong, preventing the current account deficit from correcting itself.

While inflation, productivity and savings behaviour determine a foreign currency behaviour in the long run, lots of things push it around in the short run.

Interest Rates

Countries with higher interest rates attract foreign investors who buy its bonds hoping to earn those higher rates, creating demand for the currency. Lower rates do the opposite.

This doesn’t work though if interest rates are higher only because of inflation. it’s the real interest rate (the nominal interest rate minus inflation) that matters.

Economic Prospects

When a country’s economic outlook improves, its investment opportunities look more attractive and its central bank raises interest rates to starve off inflation. Both those things attract foreign investors, bolstering the currency.

Terms of Trade

This is simply the ratio of export prices to import prices. Canada exports a lot of oil, so when oil goes up, its terms of trade improve. It earns more foreign currency on its exports. Meanwhile, foreign investors rush to buy shares in Canadian oil companies. Both those things create extra demand for Canadian dollars, therefore rising terms of trade are bullish for a currency.

Fear and Greed

Currencies are a real-time indicator of how the world feels about a country and those feelings can change quite suddenly, from overconfidence to panic.

When the world looks like a more dangerous place because of war or financial meltdown, the political and economic stability of countries such as the United States and Switzerland is particular appealing and their currencies become safe havens.

A country with a rock-solid currency can see it plummet if foreign investors suddenly lose confidence in it.

What is a Russian Peg

Many countries, particularly in the developing world, operate currency peg, where their exchange rate is tied to that of some other currency – usually the dollar or euro – or a group of currencies.

The most important peg today is the Chinese renminbi whose price is fixed to a basket of international currencies. Unlike the Eurozone, whose predecessor currencies were united to promote trade, developing countries tend to use pegs because international investors won’t lend them money in their own currencies.

(They aren’t trusted not to wipe out their debts by creating high inflation). The reason for this is that if you operate a floating exchange rate, holding debts in a foreign currency can be highly risky – any depreciation of your domestic currency will make it costlier to repay your debts using this currency.

Additionally, if international investors start to worry about your national solvency, they’ll probably sell whatever assets they own in your currency, causing it to depreciate even more which will make your debts even harder to pay off.

Technical Analysis

It is well to point out that like all markets out there, forex currencies move up, down and sideways and are driven by economic news, traders’ perceptions of such news, sentiment, rumour..etc If you check out a forex currency chart, you will notice the same kind of trends, support and resistance zones, double tops..etc as a chart of, say an individual share. As such one could apply technical analysis to foreign exchange markets in a similar way to other markets.

In Conclusion

In the long run – inflation, productivity and saving are the main drivers of foreign exchange rates and individual currencies.

In the short run – interest rates, economic growth and the terms of trade dominate.

To reduce volatility and inflation, one country will often peg its currency to another. If the fundamentals drive their values apart, the peg will eventually break.

Countries may adopt the same currency as members of the Eurozone have done, but if their fundamentals don’t converge, the currency union may not last.