10 Factors That Influence Exchange Rates - Fexco (2024)

Have you ever wondered how exchange rates are determined? As one of the leading factors behind the economic health level of any given country, exchange rates are one of the most analysed economic measures on the planet. But what exactly influences currency exchange rates and why are they so important to everyone from governments and large financial institutions to small investors?

Supply and demand dictate foreign exchange rates. For example, greater demand for British goods would see an increase in the value (appreciation) of the Pound. Markets worried about the future of the Eurozone economies would tend to sell Euros leading to a depreciation of the Euro.

10 Factors that influence currency exchange rates:

1. Inflation >
2. Interest rates >
3. Government Debt/Public >
4. Political Stability >
5. Economic Recession >
6. Terms of Trade >
7. Current account deficit >
8. Confidence and speculation >
9. Government intervention >
10. The stock markets >

1. Inflation

Inflation is a general rise in prices in an economy, i.e., goods, and services andis usually expressed in percentages.

If, for example, inflation was lower in the UK, the purchasing power of the Pound Sterling would increase relative to other currencies. UK exports become more competitive and the demand to purchase Pound Sterling for UK goods will increase.

In December 2022, the inflation rate in the European Union was 10.4 percent, with prices rising fastest in Hungary, which had an inflation rate of 25 percent.

As a result, the Hungarian forint is amongst the worst performing currencies in Central Europe since January 2022.

Research by BNP Paribas indicates that the forint has respectively lost 11 and 23 % of its value against the Euro and the dollar. It must be stated however that inflation is just one of the contributory factors here.

2. Interest rates

There is also a strong correlation between inflation, interest rates and exchange rates.

Governments and Central Banks have the authority to influence exchange rates by increasing interest rates. An example of this is “Hot money”: the higher the interest rate the more attractive the currency offer is to foreign investors.

This involves investors rapidly and frequently moving money from a currency with lower interest rates to a country with higher interest rates, giving a quick return on investment.

3. Government/Public debt

A country’s debt rating is also a factor that influences its currency exchange rate.

Public sector projects sometimes require large-scale deficit financing which boosts the domestic economy.

However, foreign investors are less likely to invest in countries with large public deficits and government debt.

Fear of a debt default can result in the selling of bonds denominated in that currency by investors, resulting in a fall in the value of the exchange rate.

Governments may also need to print money to pay parts of a large debt, resulting in inflation.

4. Political stability

The strength of a currency can also be influenced by the political stability of a particular country.

Foreign investors are more attracted to invest in countries displaying a lower propensity for political turmoil.This injection of foreign investment leads to an appreciation of the domestic currency.

Conversely, unpredictable events leading to unstable conditions in a country mean less foreign investment naturally leading to a depreciation in the domestic currency.

In October 2022, Britain was plunged into economic and political uncertainty following the resignation of the then Prime Minister Liz Truss after only 49 days in office. Her vast planned tax cuts crashed the pound and sent borrowing costs soaring.

The ‘mini budget’ announced by former Chancellor Kwasi Kwarteng would have required an unprecedented extra £411 billion in public borrowing over the following five years, pushing Britain into a crisis not seen since the 2008 financial crash.

5. Economic recession

In theory, when a country enters a recession there is normally a depreciation of its currency. Why so?

Firstly, it is commonplace for interest rates to fall in a recession and when this happens, we see a flow of money out of the country to countries with higher interest rates.

If for example, Canada entered a recession and money started to flow out of the country, its people would sell Canadian dollars to buy other currencies resulting in a fall in the value of CAD (Canadian dollar).

It must be noted that economic and political events in other countries will also influence how a domestic currency moves in times of recession.

For example, in a global recession, the United States may still be seen as a haven for investors (even though it may experience high inflation and low interest rates) keeping its currency stable or even stronger than other currencies.

6. Terms of Trade

The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the difference between the monetary value of a nation’s exports and imports over a certain time period.

The terms of trade will improve if the price of a given country’s exports rises by a greater rate than that of its imports.

A greater demand for a country’s exports means an improvement in terms of trade resulting in rising revenues and, consequently, an increased demand for that country’s currency. This will naturally increase the value of that currency.

7. Current account deficits

The current account deficit is closely related to the terms or balance of trade.

The current account measures imports and exports of goods and services but also payments to foreign holders of a country’s investments, payments received from investments abroad, and transfers such as foreign aid and remittances.

If for example, Britain, as a regular trading partner with Canada had a higher current account deficit this could weaken the pound relative to the Canadian dollar.

Countries therefore with lower current account deficits will tend to have stronger currencies than those with higher deficits.

8. Confidence and speculation

Political events or changes in commodity prices may cause a currency to fall in value. If speculators believe the Euro will fall, they will sell now for a currency they feel will rise in value. For this reason, sentiments in the financial markets can heavily influence foreign exchange rates.

If the markets are alerted to the possibility of an interest rate increase in the Eurozone for example, we are more likely to see a rise in the valuation of the Euro as a result.

If a US speculator expects the euro to appreciate over the next 5 months, he will contract to buy euros in 5 months at a fixed exchange rate. This is known as a forward contractand this mitigates any risk and losses caused by exchange rate volatility.

9. Government intervention

Governments and Central Banks have the monetary authority to intervene to stabilize a currency by formulating trade policies, printing more money, or increasing and decreasing interest rates.

China, for example, is reluctant to allow its currency to appreciate because it will negatively impact its exports.

The Chinese government aims to boost its exports and attract foreign investment by keeping the yuan artificially low. As an export dependent economy, China does so to compete with neighbouring countries like Japan and South Korea.

Given China’s large trade surplus, its central bank, the Peoples Bank of China (PBOC) absorbs large inflows of foreign capital. It purchases foreign currency from exporters and then issues that currency in local yuan currency.

10. The stock markets

Both the stock market and foreign exchange are the most financially traded markets on the globe. To help with price predictions, traders often look for correlations between both markets.

The mood of investors is buoyed when a domestic stock market rises as it is an indicator that the country’s economy is doing well.

As a result, there is increased interest from foreign investors and the demand for local domestic currency also increases.

When the stock market is underperforming, a lack of confidence means investors will take their funds back to their own currencies.

How Fexco can help you with exchange rates

Monitoring each of these factors together with current exchange rates can help you to make aninformed decision when it comes to making fx payments for business. You may also have a requirement to make international money transfers for personal reasons.

Whatever your payment requirement, opening a free account with Fexco is your first step to better FX rates and excellent support. There is no obligation to trade until you are ready to do so, and you can access expert guidance from the moment your account is opened.

Opening an account just takes a few minutes but it means that you get access to bank-beating rates and personal guidance. It also means that whenever you need to move your money, you will have experts on hand to help you make the right decisions at the right time.

Our international payment specialists can help you plan with currency risk management tools to protect against adverse currency market movements.

Get a better FX rate for your international payments

10 Factors That Influence Exchange Rates - Fexco (1)

10 Factors That Influence Exchange Rates - Fexco (2024)

FAQs

10 Factors That Influence Exchange Rates - Fexco? ›

D) Factors Influencing Floating Exchange Rates:

Speculation: Traders' perceptions of future exchange rate movements can drive short-term fluctuations. Political Stability: Political events can impact investor confidence and currency values. Trade Balance: Trade surpluses or deficits can affect a currency's value.

What are the factors that influence exchange rates? ›

7 factors affecting exchange rates
  • Interest and inflation rates. Inflation is the rate at which the cost of goods and services rises over time. ...
  • Current account deficits. ...
  • Government debt. ...
  • Terms of trade. ...
  • Economic performance. ...
  • Recession. ...
  • Speculation.

What factors influence floating exchange rates? ›

D) Factors Influencing Floating Exchange Rates:

Speculation: Traders' perceptions of future exchange rate movements can drive short-term fluctuations. Political Stability: Political events can impact investor confidence and currency values. Trade Balance: Trade surpluses or deficits can affect a currency's value.

Which of the following factors influence the exchange rate of a currency? ›

Exchange rates are influenced by a combination of economic, political, and social factors. Among these, trading partners and the presence of an active war have a more direct and immediate impact on exchange rates.

What is the greatest factor affecting a country's exchange rate? ›

Economic or Monetary policy decisions are often regarded as the most influential factor over foreign exchange (FX) rates. Central banks, like the Federal Reserve, use monetary policy to manage fluctuations in the economy and keep prices stable.

What influences foreign exchange rates on Quizlet? ›

  • Foreign demand for a country's exports. Demand for a country's exports = demand for a country's currency.
  • Domestic demand for imports. Demanding imports = supplying currency.
  • Relative interest rate changes. ...
  • Relative inflation rates. ...
  • Investment from abroad. ...
  • Speculation. ...
  • Use of foreign currency reserves. ...
  • Level of income.

What are the types of exchange rates? ›

In the foreign exchange market, there are three types of exchange rate systems in place, each with its own characteristics.
  • Fixed Exchange Rate System. ...
  • A Flexible Exchange Rate System. ...
  • Managed Floating Exchange Rate System.

What are the effects of change in exchange rates? ›

Exchange rates have a significant impact on the prices you pay for imported products. A weaker domestic currency means that the price you pay for foreign goods will generally rise significantly. As a corollary, a stronger domestic currency may reduce the prices of foreign goods to some extent.

How does inflation affect exchange rates? ›

In general, when inflation is high, it makes a currency weaker, suppressing investment, and thus negatively impacting the exchange rate. When inflation is low, a currency is stronger, improving its exchange rate.

What are the three types of exchange rates? ›

There are three types of exchange rates; namely, Fixed Exchange Rate, Flexible Exchange Rate, and Managed Floating Exchange Rate.

What is the strongest currency in the world? ›

The Kuwaiti dinar is the strongest currency in the world, with 1 dinar buying 3.26 dollars (or, put another way, $1 equals 0.31 Kuwaiti dinar). Kuwait is located on the Persian Gulf between Saudi Arabia and Iraq, and the country earns much of its wealth as a leading global exporter of oil.

Which factor does not affect currency exchange rates? ›

Explanation: Political stability is the factor that does NOT affect currency exchange rates. Currency exchange rates are determined by various factors such as economic conditions, balance of payments, and balance of trade.

Which of the following factors does not influence exchange rates? ›

Historical significance is not a factor affecting exchange rates. GDP, political stability, and economic conditions influence exchange rates.

What is the 3 strongest currency? ›

The Omani Rial, which is tied to the US dollar, is the third most valuable currency in the world.

What is the weakest currency in the world? ›

What Is the Weakest Currency in the World? The weakest currency in the world is the Iranian rial (IRR). The USD to IRR operational rate of exchange is 371,992, meaning that one U.S. dollar equals 371,922 Iranian rials.

What has the most impact on a floating exchange rate? ›

Market sentiment towards the economy of a country affects how strong or weak the floating currency is perceived. For example, a country's currency is expected to depreciate if the market views the government as unstable.

What are the three main elements supporting a floating exchange rate system? ›

Explanation: The three main elements supporting a floating exchange rate system are automatic trade balance adjustments, monetary policy autonomy, and economic recovery following a crisis.

What are the two main elements of the case for floating exchange rates? ›

The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments. It is argued that a floating exchange rate regime gives countries this.

What are the three main elements supporting a floating exchange rate system quizlet? ›

"The case in support of floating exchange rates has three main elements: monetary policy autonomy, automatic trade balance adjustments, and economic recovery following a severe economic crisis." Page 336 in the textbook.

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