Factors that Influence Exchange Rates

Exchange Rates

Whether economics or finance fancies you or not, you have encountered or have interacted with local and international currency rates. Currency exchange rates are one of the most analyzed economic measures in the world. Because of how it is affected by a country’s economic performance, it is imperative to know the factors that influence exchange rates.

What does Exchange Rates Mean?

An exchange rate is the value of a country’s currency relative to another country’s currency. For example, as of July 4, 2022, it takes 54.98 Philippine Pesos to buy one US Dollar.

From the same example, recent groundbreaking news saw the price of a US Dollar supersede 55 Philippine Pesos for the first time since October 27, 2005, when the local currency closed at 55.08 Philippine Pesos. While local news angled the story towards being problematic for the Philippines, many people did not know how to react due to lacking understanding about the situation.

On a general scale, local supply and demand dictates a country’s exchange rate. To illustrate, if Filipino products experience an increase in demand, the value of the Philippine Peso will appreciate.

If a country’s currency has a high value, then their exports are more expensive in foreign markets and their imports are cheaper.

Nevertheless, supply and demand is just one of the many variables that equate a nation’s exchange rate.

What are the Factors that Influence Exchange Rates?

Here are the different factors that influence exchange rates, making it necessary for governments, financial institutions, economists, and investors to understand it.

1. Inflation

The inflation rate refers to how fast the general prices of goods and services rise. Here in the Philippines, as of May 2022, the inflation rate is at its highest at 5.4 percent.

Due to high inflation rates, the purchasing power of the Philippine Peso is slowly diminishing. Consequently, the Philippine’s exports are weaker, their imports are more expensive, interest rates are higher, and the demand to buy Philippine Peso is low.

Real estate is one industry affected by inflation. The demand for housing has incrementally increased during the pandemic. On the other hand, producing these homes has probably been unable to keep up with the demand, leading to rising prices of houses.

The local inflation rate is one of the biggest factors that influence exchange rates. Case in point, the Philippine’s rising inflation rate has a significant effect on the underperformance of the Philippine Peso relative to the US Dollar.

2. Interest Rate

Interest rates are highly correlated to inflation rates then eventually, the exchange rate.

As aforementioned, the weakening Philippine Peso was caused by high interest rates which naturally come along with high inflation rates. High interest rates are measures used by the federal reserve or central bank in response to high inflation rates. Due to high demand and low supply, the national government is basically discouraging the public from buying.

Conversely, if inflation is low due to a surplus supply and low demand, the central bank can stimulate the economy by lowering interest rates. This is how they encourage the public to increase their consumption of goods and services.

It all boils down to central banks controlling risk. For example, during high inflation rates, they make it riskier to get a bank loan to discourage you from borrowing money.

On the flipside, when economic activity is low, they lower the interest rates, reducing the risk of borrowing as if they want you to borrow money.

3. Public Debt

Countries engage in large-scale spending for government funding or financing public sector projects. From the term “large-scale spending,” using that much money as funds likely has debt in them.

Contrary to public belief, debt is a good thing because you are granted a lot of money right now which can be paid off in the future. This is how a bank loan can be beneficial for someone in need of money right now with the confidence to pay it all back in the future

Where it can be bad depends on a country’s reputation when dealing with debt. If a country’s public deficit and debt outpaces their economic growth, it is likely that foreign investors will not be attracted.

Since large debt leads to high inflation, and high inflation rates lead to disadvantageous foreign exchange rates, the debt will be paid off in the future with cheaper money.

Aside from this, a country’s debt rating—from Moody’s or Standard and Poor’s determination—is also looked at by foreign investors which in turn, plays one of the factors that influence exchange rates.

4. Local Economic Performance

There are many indicators to look at to determine if a country is performing well economically.

First, you can look like poverty rates. Low poverty rates mean less homelessness due to effective real estate, less unemployment leading to more money to spend. With more money to spend, it is easier for the government to stimulate the economy by making everything cheap to entice more buyers.

Second, having many foreign investors helps. More foreign investors lead to lower inflation rates and interest rates, meaning a stronger local currency.

5. Speculation

An additional power of a foreign investor is their ability to control a nation’s currency based on speculation and gut feeling. If they believe that the currency will get stronger in the future, they will invest now to make a profit of it. Contrariwise, if they feel that the currency will weaken, they will back off.

Local politics is one way a foreign investor is influenced. fA foreign investor is heavily invested in politics of the nation he/she is investing at. If he/she is not in favor of the winning candidate or political party, he/she may pull out investments and businesses, especially if deemed counterproductive to economic growth.

Speculation is considered sudden, irrational, and short-lived. In a sense, real estate works the same way.

As a potential buyer, you may have preconceived notions about a certain home and/or its value that may inhibit you from buying. Hence, before any purchase, it is important to get the facts straight before jumping to any conclusions and deals.

6. Current Accounts

The current account is the balance of trade between a country and its trading partners, reflecting the difference in value between their exports and their trading partner’s imports. The current account of a nation will show all their transactions with foreign partners, coming from goods, services, and interest.

A deficit in a current account occurs when a country spends more on imports while making less from exports. In other words, if you import more than you export, you have a negative balance of trade.

A feature of this deficit is to borrow money from those foreign partners to make up the deficit. This becomes one of the factors that influence exchange rates. It will inevitably make the Philippine Peso more expensive by reducing the growth of foreign exchange reserves and increasing interest rates.

Being money-wise

Considering the economic state of the world and local economic performance of the Philippines, there is now better time than the present to be smart with one’s money. One way to start is by being familiar with the factors that influence exchange rates.

Read Also: 8 Money Saving Hacks We Learned During 2021

Now, whenever you send or receive money, or do business with foreign currency, you at least know what factors into the prices of these exchange rates. Better yet, it may propel you ponder on your spending habits and find ways to be more frugal. 

If there is one thing this global economic crisis has taught us, it is that one must be wary of how spending habits not only affect the individual, but one’s country and even the whole world.

Written by Cholo Hermoso