2011-10-17 08:53:03
Aside from factors such as interest rates and inflation, the exchange rate is
one of the most important determinants of a country's relative level of
economic health. Exchange rates play a vital role in a country's level of
trade, which is critical to most every free market economy in the world. For
this reason, exchange rates are among the most watched, analyzed and
governmentally manipulated economic measures. But exchange rates matter on a
smaller scale as well: they impact the real return of an investor's portfolio.
Here we look at some of the major forces behind exchange rate movements.
Overview
Before we look at these forces, we should sketch out how exchange rate
movements affect a nation's trading relationships with other nations. A higher
currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets. A higher exchange rate can be
expected to lower the country's balance of trade, while a lower exchange rate
would increase it.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and
are expressed as a comparison of the currencies of two countries. The following
are some of the principal determinants of the exchange rate between two
countries. Note that these factors are in no particular order; like many
aspects of economics, the relative importance of these factors is subject to
much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other
currencies. During the last half of the twentieth century, the countries with
low inflation included Japan, Germany and Switzerland, while the U.S. and
Canada achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the currencies of
their trading partners. This is also usually accompanied by higher interest
rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation
and exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign
capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest
rates tend to decrease exchange rates. (For further reading, see What Is Fiscal
Policy?)
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services,
interest and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for
its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for
foreigners, and foreign assets are too expensive to generate sales for domestic
interests. (For more, see Understanding The Current Account In The Balance Of
Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to
foreign investors. The reason? A large debt encourages inflation, and if
inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large
debt, but increasing the money supply inevitably causes inflation. Moreover, if
a government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply
of securities for sale to foreigners, thereby lowering their prices. Finally, a
large debt may prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great. For
this reason, the country's debt rating (as determined by Moody's or Standard &
Poor's, for example) is a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related
to current accounts and the balance of payments. If the price of a country's
exports rises by a greater rate than that of its imports, its terms of trade
have favorably improved. Increasing terms of trade shows greater demand for the
country's exports. This, in turn, results in rising revenues from exports,
which provides increased demand for the country's currency (and an increase in
the currency's value). If the price of exports rises by a smaller rate than
that of its imports, the currency's value will decrease in relation to its
trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can
cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived
from any returns. Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from domestic
securities. While exchange rates are determined by numerous complex factors
that often leave even the most experienced economists flummoxed, investors
should still have some understanding of how currency values and exchange rates
play an important role in the rate of return on their investments.
For further reading, see Floating And Fixed Exchange Rates.
by Jason Van Bergen