Exchange rates are determined by a variety of factors and discussing those key factors that affect currency exchange rates. They are connected to the trading relationship between the trading partners. Remember that currency exchange rates are a relative term that describes the value of one currency concerning another. Before looking deeper into the reasons for currency depreciation or appreciation, it is necessary to consider the consequences of international capital flows. When foreign financing available to countries abruptly disappears, this phenomenon is described in the economic literature as a “ sudden stop,” in which countries are forced to undergo potentially painful resource transfers to creditor countries. When this occurs, an outstanding current account deficit that was previously financed through foreign capital inflows must be eliminated or financed through international reserve losses. Experience has shown that developing countries, as opposed to developed countries, are experiencing abrupt declines.
Sudden halts in gross capital flows are linked to financial instability, particularly when the gross flows are dominated by volatile cross-border banking flows. Sudden halts in gross and net capital flows are examples of externally triggered episodes. This implies that the spark that ignites sudden stops comes from outside the affected country: specifically, the supply of foreign financing, which can halt for reasons unrelated to the affected country’s domestic conditions. However, unless combustible materials are present, a spark cannot start a fire. According to the literature, a set of domestic macroeconomic fundamentals is the combustible material that makes some countries more vulnerable than others. Higher fiscal deficits, larger current account deficits, and higher levels of foreign currency debt in the domestic financial system are symptoms of weak fundamentals that increase vulnerability. When the crisis occurs, these same factors raise the costs in terms of output losses. On the other hand, international reserves act as buffers, allowing countries to mitigate risks. Holding foreign currency reserves protects the government’s fiscal position, giving it more resources to respond to the crisis. While it may be impossible for countries to completely protect themselves from the volatility of capital inflows, the choice of antidotes to prevent that volatility from forcing potentially costly external adjustments is entirely in their hands. The global financial architecture can be strengthened to support those efforts if countries agree on and fund a more powerful international lender of last resort, similar to the role of the Federal Reserve Bank in promoting financial stability in the United States on a global scale.
Foreign investors can cause sudden stops by reducing or stopping capital inflows into an economy, and/or domestic residents can cause capital outflows by withdrawing their money from the domestic economy. Because abrupt stops are typically preceded by robust expansions that drive asset prices significantly higher, their occurrence can have a significant negative impact on the economy and tip it into a recession. According to the World Bank, sudden stops have both financial and real assets consequences. The first to manifest the financial effects: the currency exchange rates fall, reserves fall, and equity prices fall. GDP growth then slows, investment slows, and the current account improves. GDP growth falls by roughly 4% year on year in the first four quarters of a sudden halt.
Before delving into these forces, we should consider how currency exchange rates movements affect a country’s trading relationships with other countries. In foreign markets, a higher currency value makes a country’s exports more expensive and imports cheaper; a lower currency value makes a country’s exports cheaper and imports more expensive. A higher exchange rate is likely to reduce the country’s trade balance. whereas a lower exchange rate would raise it.
DETERMINANTS OF EXCHANGE RATES
Currency exchange rates are determined by a variety of factors, all of which are related to the countries’ trading relationships with their trading counterpart. The following are some of the major determinants of a country’s exchange rate. It should be noted that these factors are not in any particular order; the relative importance of these factors, like many other aspects of economics, is widely debated.
1. DIFFERENTIALS IN INFLATION
In general, a country with consistently lower inflation has a rising currency value, i.e., appreciation tendency. As a result of lower inflation, its purchasing power grows in comparison to other currencies. Countries with higher inflation typically see their currency depreciate with the currencies of their trading partners. This is usually accompanied by an increase in interest rates. Why does inflation have an impact on exchange rates? To comprehend inflation’s negative effects on currency exchange rates, it is necessary to understand the relationship between inflation and interest rates, as well as the relationship between exchange rate and interest rate.
2. DIFFERENTIALS IN INTEREST RATES
The most basic explanation for inflation is that it reduces the purchasing power of money. Assume there is 10% inflation and anything that can be purchased with Rs.100 today will require 100 x 1.1 = Rs.110 to purchase the same thing one year from now. However, when we consider lending and borrowing, things become a little more complicated. For the sake of simplicity, let’s say you have Rs 1,000 and the price of a pizza is Rs 50 per piece, which means you can buy 20 pizzas with Rs 1,000. Assume there is an investment opportunity that guarantees a 15% annual return. In a year, your wealth will increase to Rs 1,150 (1,000 x 1.15) in nominal terms, but in real terms, it will be less. Assume that the expected inflation rate from now on is 10%; therefore, the price of pizza would be Rs 55/piece, implying that you can now buy 1,150/55 = 20.91 pizzas with this amount of money. In reality, your wealth increased by 4.55 percent [(20.91–20)/20] rather than 15 percent. If you use the Irving Fisher formula (1 + R = (1+r) x (1+ h), where R is the nominal interest rate, r is the real interest rate, and h is the inflation rate, you will get the same 4.55 percent real interest rate. When we try to understand the impact of inflation in the context of international trade, things become more complicated. The theory of interest rate parity attempts to explain the complex relationship between interest rates and inflation. I explained it in the following paragraphs without using any mathematical formulas.
Interest rates, inflation, and currency exchange rates are all highly correlated with one another. Central banks exert influence over both inflation and exchange rates by manipulating interest rates, and changes in interest rates affect both inflation and currency values. Higher interest rates provide lenders in an economy with a higher return in comparison to other countries. As a result, higher interest rates entice foreign capital, causing the exchange rate to rise. However, higher interest rates are mitigated if inflation in the country is significantly higher than in others, or if other factors serve to drive the currency down. Lower interest rates tend to decrease exchange rates, whereas higher interest rates tend to increase them. To illustrate interest rate parity, consider the case of a US investor who can buy a risk-free 90-day Pakistani’s T-Bill that promises a 7.3019 percent nominal return. The 90-day interest rate would be 7.3019% / 4 = 1.8255%. Assume also that the spot exchange rate is $0.009416, which means that you can exchange 0.006269 dollars for one PKR, or 159.5073 PKR per dollar. Finally, assume that the 90-day forward exchange rate is $0.009295, which means that you can exchange one PKR for 0.006176 dollars, or receive 161.9157 PKR per dollar 90 days from now. The US investors can receive a 7.3019 percent annualized return denominated in PKR, however, if he or she ultimately wants to consume goods in the United States, those PKR must be converted to dollars. The dollar return on the investment depends on the exchange rate in the next three months. However, the investor can lock in the dollar return by selling the foreign currency in the forward market. For example, the investor could simultaneously Convert $1,000 to 159,507.30 PKR in the spot market and invest the 159,507.30 PKR in a 90-day Pakistani T-Bill that has a 7.3019 percent annualized return or a 1.8255% quarterly return. That will pay (159,507.30) x (1.08255) =162,419.11 PKR in 90 days. If he agrees today to exchange these 162,419.11 PKR 90 days from now at the 90-day forward exchange rate of 161.9157 PKR per dollar or for a total of $1,003.11. This investment, therefore, has an expected 90-day return of [(1,003.11 — $1,000)/$1,000] = 0.3109%, which translates into a nominal return to 4(0.3109%) = 1.24%. In this case, 7.3019 percent of the expected 1.24 percent return is coming from the bond itself and 6.0619 percent arises because the market believes the PKR will weaken relative to the dollar.
And USD / PKR = 161.9157 in forward market (13-week US T-Bill rate is 6%)
This is a standard way to quote currencies, such as USD/PKR, where the numerator is the base currency, and the denominator is the quote currency. It shows how much of the quote currency is required to buy one unit of base currency. Using the above information (and assuming that the US T-Bill rate remains constant because the USD is a stable currency), and plugging it into the following formula, we can estimate what the market expects the Pak T-Bill rate to be 90 days from now in forward contract.
Quoted forward the rate indicates the market is anticipating inflationary pressure will persist shortly.
In the next post, I will discuss other currency exchange rates theories with equally significant factors like, Current account deficit, fiscal deficit, term of trade, and political stability, that influenced the exchange rate.