How Are Foreign Exchange Rates Affected?

This article covers the various factors that may affect the foreign exchange rates of a country.

What Affects Foreign Exchange Rates

A country’s currency value is indicated by its foreign exchange rates compared to other countries.  There are many factors that affect the determination of a country’s foreign exchange rates.

Public Debt

When a government is unable to meet its public debt repayments, investors may speculate that it will be unable to meet all its debt repayments.  This will put them on the alert regarding their investment.  It may serve as a warning that the country could be heading toward a debt default which will decrease the value of the country’s currency.  This potential for a currency rate decline is the reason why you should consider the debt rating of a country when you are in the process of foreign exchange rates predictions.

Countries make use of massive amounts of financing when they require funding for public sector projects or when they need government funding.  This type of activity often boosts the economic climate of the country, but it could limit foreign investment as its high debt ratio will not attract investors.  The large public debt could increase the inflation rate which will cause the currency to devalue.  This decline in currency value ultimately increase the cost of the debt the country has raised.

When governments are in this situation, they often make the decision to print more money.  This usually causes an increase in the inflation rate.  If it is not possible for the country to service its debt by increasing its money supply, it may be necessary for it to start selling off its bonds.  If this method fails, it may become necessary for the government to sell off its securities to foreigners.  If its currency has already devalued, the price they receive for these securities will be below its normal value.

Inflation

The rule regarding inflation and forex rates is that a country with a consistently low inflation rate will experience higher foreign exchange rates.  This is because the country has increased purchasing power compared to its trading partners.  Countries with high interest rates often suffer a decrease in the value of its currency.

Foreign Exchange Rates and Current Account Deficit

A country’s current account is reflective of its trade relationships with other countries.  The account represents the payments countries make to their trading partners in respect of interest, dividends, goods and services.  If the current account shows a deficit, it means that the country has disbursed more funds than it received as income.  It also means that the country is borrowing from its trade partners to eliminate the shortfall.  This need for borrowing from other countries can be seen as a clear indication that the foreign exchange rate of the country will decrease.

Interest Rates

The inflation rate, exchange rate and interest rates of a country are all linked.  If the central bank makes the decision to manipulate interest rates, it will have a direct impact on the forex rates and the inflation rate.  If the bank increases its interest rates, the currency becomes more attractive to investors as they are able to obtain a higher yield on their funds.  This is the reason why high interest rate countries attract foreign investment which pushes up its currency rate.  The effect of the higher interest rates could be affected if the inflation rate surpasses that of other countries or if there are other factors, such as political stability, which may pull down the forex rate.  The normal result of lowered interest rates is lower foreign exchange rates.

 

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