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.
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.
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.
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.
source : Jason Van Bergen
on
July 23, 2010
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