| What Moves Foreign Currency Exchange Rates? |
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A variety of factors explain the movements of foreign currency exchange rates over the long term. Although rigid, formula based models work very well in explaining the currency movements in the short term, they fall short in predicting exchange rate levels over the long term. Currencies are noted for their long term trends and in this article, we cover the most important factors that determine the level of exchange rates.
Balance of Payments
It's logical to think that a country that continues to import a lot more than it exports will have a weakening currency. Currently, the U.S. imports lots of goods from China because of their low cost. In order to return this trade relationship to "equilibrium", the U.S. Dollar needs to weaken versus the Chinese currency so that Chinese goods will be more expensive for the U.S. to import, thus decreasing demand. For this reason, China does not allow its currency to freely float versus the U.S. Dollar, but this example forms the basis for the balance of payment model, and is the key argument in why some people expect the U.S. Dollar to weaken versus other currencies.
The balance of payments model looks strictly at a country's current account which contains the total value of all tradeable goods and services. An account surplus is likely to lead to a stronger currency, whereas an account deficit is likely to lead to a weaker currency. One way to think about this is that is if your economy is very productive and produces goods and services that are in demand worldwide, people will need to have your currency in order to purchase your goods. Thus, in the currency markets, the currency strengthens versus others due to high demand from individuals, corporations, and banks. Again, its very logical since you would expect those countries that produce the majority of the valuable goods and services to have the strongest currencies.
Flow of Funds
The flow of funds model looks at a country's capital account which keeps records of the exchange of money between countries for the purpose of purchasing capital assets. This includes foreign direct investment, portfolio investment (such as changes in holdings of stocks and bonds), and other investments (such as changes in holdings in loans, bank accounts, and currencies). For example, to counteract its current account surplus with the U.S., China runs a large deficit in its capital account with the U.S. To prevent its currency from appreciating, its central bank purchases dollars in the FOREX market, and then uses those dollars to invest in U.S. Treasuries (a capital asset). From the point of view of the domestic country, when a foreign country purchases a domestic asset, it increases the value of the capital account, and when the domestic country purchases a foreign asset, the value in the capital account decreases. Surpluses in the capital account lead to a strong currency whereas a deficit will produce the opposite.
Capital flows are usually influenced by yield differentials between countries. The level of interest rates in each country is primarily influenced by the actions of its central bank. The central bank is responsible for monetary policy and setting an "official interest rate"; the rate at which other member banks can borrow overnight funds from the central bank. Perhaps the best example of this is Japan, which in the 1990's adopted a zero interest rate policy, where the central bank maintained a 0% nominal interest rate. As a result of low short end rates in Japan, investors borrowed money in yen at low overnight rates, exchanged their yen for U.S. Dollars in the FOREX market, and then purchased U.S. Treasuries with the proceeds. This was known as the "Yen Carry Trade", and it allowed investors to capture large yield differentials across markets in different countries. As a result, the U.S. Dollar strengthened versus the Japanese Yen. Carry trades are popular among FOREX investors and will lead to countries with lower real interest rates also having weaker currencies.
Inflation Rate
High nominal interest rates might not indicate a strong currency, as the inflation rate may be high as well. Inflation erodes the purchasing power of a particular currency and occurs when the growth in the money supply is higher than the growth in GDP (Gross Domestic Product = the dollar value of all goods and services produced within a country’s borders in a given year). If GDP remains constant with a money supply that is increasing, you end up having more money chasing the same amount of goods, leading to higher prices and a weaker currency.
The concept of purchasing power parity states that the cost of an identical good should be the same around the world. For example, if a candy bar cost US$1.25 or 1 Euro, PPP would imply that the EUR/USD exchange rate is 1.25. If there were inflation in the U.S. and the same candy bar in the U.S now cost $2, yet the price of the candy bar in Euros is unchanged, the U.S. currency would have weakened with the EUR/USD rate now equal to 2.
Technical Factors / Market Psychology
The majority of currency trades are purely speculative in nature and are designed to profit from short to medium term trends. Currency traders will make trades in anticipation of economic announcements such as GDP or inflation numbers, or central bank rate announcements. Other traders may trade purely on a technical nature, looking for trends and chart patterns that are likely to produce profitable trades. There may be a "flight to quality" in a particular currency as a result of worldwide economic stress. The strengthening of the U.S. Dollar in the latter half of 2008 is a great example of "flight to quality".
Political Conditions
Political events have the ability to completely reshape a country, its stability, and its economic policies. Destabilization of a government is likely to have an adverse effect on its currency as the country's economy is likely to suffer. Currency traders constantly monitor political events within countries and currency values will move in anticipation of a new political regime.
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