Many an investor has wondered what impacts foreign exchange rate for a given currency. Forex markets are complex and dynamic, with myriad factors that influencing a currency’s exchange rate. It’s important to note that despite these factors, it is still difficult to predict the effect that any one event will have on a currency’s value.
A country with relatively low inflation will see a rise in currency value. That country’s currency has more purchasing power relative to its trading partners’. In addition, low inflation means decreased demands for imports and increased demand for the goods from the home country, keeping inflation low by increasing demand for goods in the home currency.
Government Intervention and Debt
A great example of government intervention in currency rates is the Chinese government’s efforts to keep the value of the Chinese yuan down. To do so, the government sells yuan and buys other currency (usually USD), decreasing demand for the yuan, and keeping its value low. This has the direct effect of allowing Chinese exports to remain attractively priced to the rest of the world. In addition to devaluing the currency, governments can be what impacts foreign exchange rate by engaging in large-scale debt financing. When a country carries a lot of public debt, it becomes less attractive to foreign investors. This usually leads to inflation. In some cases, a government will print more money to pay off the debt, which inevitably causes inflation.
Most of a currency’s value is tied to supply and demand. When demand for a currency is high, the currency’s value rises. Currency traders who are buying a currency just to sell it later increase demand for the currency, thereby increasing its price. If speculators think a currency’s value is about to go down, they will sell it, ensuring the currency’s decrease in value.
If interest rates are high in a country, investors can count on a better return on investments made there. Generally, this causes that country’s currency to rise as demand for it goes up.
Current Account Deficits
If a country spends more on foreign trade than it takes in, it is running a current account deficit and must borrow from foreign sources to make up the difference. Demand for foreign currency leads to excess supply for the home currency, devaluing the home currency and frequently causing investors to pull their investments from the country.