Forex rates are extremely unpredictable and it is highly essential for those involved with forex - either as a buyer, seller, speculator or institution - to know why rates move. In reality there are a number of factors like market sentiment, the state of the economy, government policy, demand and supply and many others.
The more important ones that have some bearing on exchange rates are discussed below.
Power of the Economy
An economy’s strength and power affects the demand and supply of foreign currency. If it is growing fast and is strong it will attract foreign currency thus strengthening its own. On the other hand, weaknesses result in an outflow of forex. If a country is a net exporter the inflow of forex far surpasses the outflow of its own currency. The result is usually a strengthening in its value.
Political and Psychological Factors
Political or psychological factors are believed to have an impact on forex rates. Many currencies have a tradition of behaving in a particular way such as Swiss francs which are known as a sanctuary or safe haven currency while the dollar moves both ways whenever there is a political catastrophe anywhere in the world. Forex rates can also oscillate if there is a change in government. Some time back, India’s forex rating was downgraded due to political instability. Consequently, the external value of the rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan, the Pakistani rupee weakened.
Economic Prospects
Forex rates move on economic opportunities. Since such expectations affect the external value of the rupee, all economic data – like the BoP, export growth, inflation rates - are analysed and its likely impact on forex rates is studied. If the economic slump is not as bad as anticipated the rate can even escalate. The change actually depends on the market sentiment i.e. the disposition of the market and how much it has reacted or discounted the anticipated information.
Inflation Rates
It is widely believed by economists that forex rates shift in the direction required to offset comparative inflation rates. If a currency is already overvalued, i.e. stronger than what is justified by inflation rates, depreciation sufficient to rectify that position can be expected and vice versa. It may be noted that an exchange rate is a comparative price and hence the market weighs all the factors in comparison to the other countries. The fundamental reasoning behind this principle is that a comparatively high rate of inflation reduces a country’s strength in the market and weakens its power to sell in global markets. This further will deteriorate the domestic currency by reducing the demand or expected demand for it and increasing the demand or expected demand for the foreign currency resulting in increase in the supply of domestic currency and decrease in the supply of foreign currency.
Movement of Capital
The movement of capital is one important reason for changes in forex rates. It is highly linked to the respective country’s global trade. This happens due to a number of reasons - both positive and negative. When India began its economic liberalisation, privatization and globalization (LPG) in 1991 and invited Foreign Institutional Investors (FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the country weakening the currency. These were capital outflows. One of the reasons popularly believed for the rupee not depreciating in the manner other South-east Asian currencies did in 1997-98 was because the rupee was not convertible on the capital account.
Speculation
Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in Nigeria is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Nigeria currency.
The most famous speculator in foreign currency is George Soros who made over a billion pounds sterling in Europe by correctly predicting the devaluation of the pound and then is believed to have triggered the free fall of the currencies of South-east Asia.
Balance of Payments (BoP)
A net inflow of foreign currency tends to strengthen the home currency vis-à-vis other currencies as the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the BoP. If it is positive and forex reserves are increasing, the home currency will become stronger.
Government’s Monetary and Fiscal Policies
Governments, through their monetary and fiscal policies have an effect on international trade, the trade balance and the supply and demand for a currency. Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will slow economic growth and this will reduce demand for imports and encourage exports. The effectiveness of the policy depends on the price and income elasticities of demand for the particular goods. High price elasticity of demand means the volume of a good is sensitive to a change in price.
Monetary and fiscal policies support the currency through a reduction in inflation. These also affect exchange rate through the capital account. Net capital inflows supply direct support for the exchange rate.
Central governments control monetary supply and they are expected to ensure that the government’s monetary policy is followed. To this extent they could increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation, restricts and cuts money supply.
In order to maintain exchange rates at a certain price the central bank will also intervene either by buying foreign currency (when there is an excess in the supply of foreign exchange) and selling foreign currency (when demand for foreign exchange exceeds supply).
It must be noted that the purpose of monetary policy is to maintain strength and economic growth and central banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or by open market operations - maintain stability.
Exchange Rate Policy and Intervention
Exchange rates are also influenced by anticipation of change in regulations relating to exchange markets and official intervention. This can level an otherwise chaotic market. Intervention is the buying or selling of foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur.
Interest Rates
An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. In this respect the growing assimilation of financial markets of major countries, the development in telecommunication facilities, the growth of specialised asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign trading as profit centres per se and the enormous opportunity for bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate volatility.
High interest rates attract speculative capital moves so the announcements made by the Federal Reserve on interest rates are usually eagerly awaited - an increase in the same will cause an inflow of foreign currency and the strengthening of the US dollar.
Licences, Tariffs and Quotas
Tariffs and quotas exist to protect a country’s foreign exchange by reducing demand. Till before LPG, India followed a policy of licences, tariffs, quotas and restrictions on imports known as the licence raj. Very few items were permitted to be freely imported. Additionally, high customs duties were imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not popular internationally as they tend to close markets. When India lifted its barriers, several industries such as the mini steel and the scrap metal industries collapsed (imported scrap became cheaper than the domestic one). Quotas are not restricted to developing countries. The United States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese goods.
Currency Regulation
The purpose of currency/exchange regulation or currency/exchange control is to administer the supply and demand balance of the home currency by the government using direct controls essentially to protect it. Currency control is the limitation of using or availing of foreign currency at home/abroad.
In India, up to LPG in the 1990s there was very severe currency control. Gaining access to forex was tightly controlled and it was released only for limited purposes. This was because Indian exports had not taken off and there were still large imports. There are several countries that maintain their rates at artificial levels such as Bangladesh.
India is now fully, convertible on the current account but not as yet on the capital account. This, to an extent, possibly rescued India when the run on currencies took place in Asia in 1997. If the Indian rupee was fully convertible and there were no exchange control restrictions, the rupee would have been open for speculation. There would have been large outflows at a time of distress resulting in a cumulative fall in its value.
As long as the par value system prevailed, the rates could not go beyond the upper and lower intervention points. The only real question under the fixed rate system was whether the BoP and forex reserves had gone down to such an extent that devaluation was imminent or possible. Countries with strong BoP and reserve positions were hardly called upon to revalue their currencies. Hence, a protection had to be kept only on deficit countries. However, under generalised floating regime, forex rates are affected by a large number of economic, financial, political and psychological factors. But the comparative significance of any of these factors can be different from time to time making it tough to forecast precisely how any particular aspect will influence the rates and by how much.
Conclusion
Forex rates are vibrant and frequently changing due to a number of reasons - market sentiment, political happenings, economic situations, interest rates, inflation, government policy and speculation. Many of these are normally short-term but can extend to the medium and long-term. Exchange rate management is a fine skill and needs to be developed carefully as it has an effect on the long-term strength of the economy and the country’s success in foreign trade.
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