Monitory Policy
If
the Central Banks thinks that any sort of intervention in the foreign exchange
market would remain consistent with the monitory policy of the government, it
will take part in the trading of foreign exchange and in the influencing of the
exchange rates. Generally, a central bank does this by the buying and selling
of the home currency in order to stabilize it to a required level.
For
example, when 1987 was at an end, the US Dollar was under the effect of major
continuous depreciation and in order to stabilize the value of US Dollar, the
finance ministers of the country released a joint statement that they would be intervening in the forex
market.
Political Situation
Political
situation of a country is very effective in influencing that country’s exchange
rates. Any political tension will result in instability of the exchange rates.
If there is political instability in a country, then there will be irregular
inflow or outflow of that country’s currency. Such irregular behavior in a
country’s currency purchases causes fluctuations in its exchange rates. And if
the political situation of any country is stable then it will experience stable
exchange rates.
For
example, during the Kosovo war for three consecutive months the Euro fell by 10
perecnt against the US Dollar because of downward pressure of the war.
Balance of Payments
Balance
of payments of a country reflects all its economic dealings of that country
with the rest of the world. Balance of payments of a country also causes
fluctuations in the exchange rates. It also affects the demand and supply of
that country’s currency. Any sort of economic activity that results in an
inflow of foreign investment will result in foreign revenue. Only the home
currency of a country is allowed to be circulated in it so the foreign currency
will have to be converted to domestic currency first which creates a supply of
those foreign currencies in the foreign exchange market. Whereas, all those
economic activities that result in an outflow of capital would result in
domestic currency being converted to foreign currency and create a supply of
domestic currency in the forex market. Both of these and other imbalances in
the balance of payments cause fluctuations in the foreign exchange markets.
For
example, one of the reasons of dollar depreciation in the United States in
2006-2007 was a current account deficit in the country of 7 percent.
Interest Rates
If
one country’s interest rates go higher or lower in comparison to another
country’s currency, then the country with the higher interest rates will be
bought in order to gain high returns. Since this will create a demand for that
currency, then its value will increase as compared to other currencies.
For
example, one of the reasons for the fall in the value of UK Pound Sterling in
2007 to 2009 was a 0.5 percent drop in the interest rates.
Market Judgment
There
is no logical or set pattern on which the foreign exchange market works. There
are certain irrational and intangible factors at work as well such as emotions,
rash behavior of the people, analysis, judgments, comprehensions etc. It is the
job of market operators to interpret the data and make judgments as to how the
market will behave based on those interpretations and these will also be
reflected on the prices. If the actual market actions deviate from the
judgments and reports, then there are seen fluctuations in the exchange market.
For
example, the market judged ahead of time the drop in the value of Canadian
dollar during the time period of 1997 to 1999.
Speculation
Speculation
of the market rates is also another factor that affects the exchange rates. Mostly,
the transactions are speculative trading while in reality the percentage of
those transactions that are linked to international trades is lower.
Speculation sometimes forces a certain action like it may result in a frenzy
buying of one currency which will end up fulfilling the prediction. On the
other hand, if a market speculates a certain drop in the value of some
currency, then it might also result in people selling the currency and end up
force proving the speculation.
For
example, from 1960s to 1970s, there were many scandals in the US including the
Vietnam War and Watergate scandal. The Speculators predicted a drop in the
value of US dollar and it did drop as well.
Inflation
Countries
that have low inflation rates get their currency values appreciated. If
inflation is low in one country, then it means that the prices of the goods of
that country will be lower as compared to the same kind of goods of other
countries. This kind of competition will result in people willing to purchase
that currency in order to purchase goods from there and this will create a
demand for that currency in the forex markets.
For
example, in 2008 there was extremely high inflation in Zimbabwe due to which
one US Dollar became equal to 600,000,000,000,000,000 Zimabwean Dollars.
Change in competitiveness
If
the goods of one country start competing with other international goods of the
same kind, then it will also create a demand for that currency in the forex
market as people will have to purchase that currency in order to purchase those
goods and its exchange rates will rise.
For
example, when Japanese Yen increased in value then its people could afford more
of the international goods.
Relative strength of other currencies
If
the strength of some major currency is in doubt, then people will start
purchasing other currencies that they deem safer and this will create a demand
for it in the forex market, pushing its exchange rates higher.
For
example, after 2007 when Benzair Bhutto was assassinated in Pakistan, people were
in doubt of the strength of the currency and started selling it which resulted
in a decline in its value in the forex market.
Government Debt
The
value of a debt that a government is under also influences the exchange rates
of that currency. For example, if there is a fear of the government defaulting
on its debt then investors will start selling that currency which will cause
its exchange rates to fall.
For
example, Iceland had major debt problems in 2008 due to which the currency of
the country saw a very rapid fall in its value.
Government Intervention
Governments
sometime intervene in the foreign exchange markets to keep the values of their
currencies at a set level. If they want their currencies to be appreciated then
they will purchase their own currencies at the exchange market, thus keeping
the currency value high.
For
example, to make their products remain competitive in the international market,
the Chinese government intervened to have Chinese Yuan devalued in comparison
of US Dollar.
Economic growth / recession
In
case of recession in the economy, the interest rates of a country fall which is
why its currency gets depreciated. On the other hand, when there is growth in
the economy, the interest rates go up, causing an appreciation in the value of
that currency.
For
example, when there was severe recession in the UK, the UK Pound Ssterling fell
nearly 20 percent in its value in the international market.
Trade Balance
The
trade balance or balance of trade of a country is the value that we get after subtracting
its total imports from its total exports. The country has favorable balance of
trade if the resultant is positive and unfavorable if it is negative. It
impacts the supply and demand of the currency of the country. In case of
favorable balance of trade, demand for its currency increases, whereas, it
falls down in the other case
Public Debt
Governments
usually engage in the activity of deficit financing at a large scale in order
to make payments for capital or public projects. Even though such activities
are good for the domestic economy, yet such large public debts and public
deficits give a poor impression to foreign investors. Increase in money supply
and large debts also result in an inflationary situation in the economy due to
which currency value gets lowered.
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