What Drives Exchange Rates?

 

Along with plunging oil prices, volatility within the foreign exchange markets has far-and-away been one of the most paramount headlines of the waning months of 2014; however, despite the visibility and relevance of the issue, many individuals remain uninformed as to what exactly drives changes in exchange rates.

 

At their core, currencies are much like any other asset: their values are determined by the global equilibrium of demand versus supply. When a certain currency experiences strong demand, its value will increase, and vice-versa when its supply is increased or demand lessens. Complexity is added due to the fact that currencies are always quoted in pairs, relative to another country, and therefore operate as a ‘zero sum game’. If one currency becomes stronger, another will become weaker at its expense. From this, we can simplify the question to: what are the key factors which cause the demand and supply of certain currencies to change? Although there are a multitude of factors, the most important ones are discussed below.

 

 

Inflation:

 

Inflation rates in a respective country have a negative correlation with currency demand; that is, the lower the inflation rate exhibited in a country, the higher the demand for that country’s currency. This is because the prices of domestic products will be expected to rise slower than their international counterparts, which will increase demand for that country’s product, and decrease the demand for imports from other countries. For example, if cars manufactured in Canada are rising in price by 5% every year, and those manufactured in Europe are rising in price by 10% per year, individuals – regardless of their country of residence – will be more likely to purchase cars from Canada, and Canadians will be less likely to buy foreign-manufactured cars. In order to pay for these products, international buyers will need to exchange their currency for Canadian dollars, which will raise the demand for the Canadian currency and increase its value relative to that buyer’s home currency. On the same note, Canadian residents, who are buying less international products, will lower their demand for certain foreign currencies, and cause those currencies to depreciate in value relative to the Canadian dollar.

 

 

 

Interest Rates:

 

The interest rates available in a country are also a primary determinant of exchange rates, as they represent the return achievable through holding sovereign debt in that country. Interest rates have a positive correlation with currency strength; the higher the interest rate in a country, the higher the demand for that country’s debt, and thus, the stronger the exchange rate. For example, if the interest rate offered on the 10-year Canadian bond increases to 5%, and the interest rate on the 10-year U.S. bond is at 2%, more international investors will want to hold Canadian bonds, and will therefore need to demand more Canadian dollars and appreciate the exchange rate. Of course, other factors here come in to play as well such as safety, political environment, and economic strength, however, for the purpose of simplification, it is still generally true that rising interest rates will result in an increased demand for that country’s currency.

 

 

 

The Balance of Payments:

 

An individual country’s balance of payments is another important factor in the world of exchange rates. The balance of payments is simply the difference in value between the goods a country imports, and the goods it exports. If the value of imports exceeds the value of exports, the country will have what is known as a ‘current account deficit’, which will, all else equal, result in currency depreciation. On the flip side, if the value of a country’s exports exceeds the value of its imports, this will cause the currency to depreciate. The reason for this is similar to what we have discussed before. In order for a country to import goods, it will need to exchange its currency for a foreign one, and in order for other nations to buy that country’s exports, they will need to buy its currency. That being said, a country can also mitigate the effect of this mechanism through capital inflows. For example, although the U.S. imports a larger gross value of goods than it exports, there is sufficient demand for U.S. Dollar-denominated investments that the effect of this current account deficit is mitigated. Capital inflow levels are inherently linked to many other factors discussed in this note, such as the competitiveness of a country’s goods, its interest rates, and its rates of inflation.

 

 

 

Government Debt:

 

As a general rule, government debt tends to have a negative correlation with currency demand, meaning that the more debt a government takes on, the less demand there is for that government’s newly issued debt, due to risk of repayment. If a country is heavily debt-laden, and investors are worried about their ability to repay, they will sell that country’s bonds in favour of others. Factors such as political stability and economic growth can mitigate this effect, however. For example, although the U.S. has a large amount of debt, there is very little worry about their government’s ability to repay, so this has little effect on the value of their currency.

 

 

 

Government Intervention:

 

Intervention is another way that government can directly affect exchange rates, and it can do so through manipulation of the supply of its currency. Remember, the higher the supply there is of a given currency, relative to demand, the lower its value. An example is the recently-completed Quantitative Easing initiative in the U.S. This process created a large amount of new U.S. Dollars, and therefore had a downward effect on the currency’s value. Another good example is China, whose government actively seeks to peg the value of the Yuan to the value of the U.S. dollar. They are able to do this through manipulation supply, or buying U.S. Dollar denominated assets and selling Yuan. This will increase the demand for U.S. Dollars, and decrease the increase the supply of Yuan.

 

 

The Relative Strength of other Currencies:

 

Often times, some currencies can appreciate regardless of the presence of other traditional factors, simply due to activities occurring in other nations. A good example of this is the current situation with the U.S. Dollar. One large reason that the USD is strengthening at the moment is due to global growth concerns in many other major markets, namely Europe and China. By contrast, the U.S. economy is doing much better, which has resulted in a ‘flight to safety’ to the American currency. Canada, to a lesser extent, is also a ‘flight to safety’ currency, as countries with stable geo-politics and government are typically the primary beneficiaries of such trends.

 

 

 

 Changes in Competitiveness:

 

If certain innovations are made within a country in regard to a certain popular product or manufacturing process, this will also drive up demand for that country’s product, as more individuals will buy that product from that country. For example, if a large Canadian company were able to create a revolutionary product which was exclusive to Canada and demanded through-out the world, this would increase the demand for that product, and therefore the Canadian dollar.

 

 

 

Speculation:

 

Much like other asset prices, market speculation plays an important role in the pricing of exchange rates. Traders can drive up currency prices by either using derivatives or by buying the physical currency and holding it, however, their speculation will most likely be rooted in the belief that one of the previously mentioned factors is likely to change in the near future.

 

The falling Canadian Dollar:

 

Using the information above, it is easy to see why the Canadian Dollar has been depreciating lately. Canada is in a difficult situation, because our primary export is oil, and the price of oil has fallen immensely over the past six months. In conjunction, the U.S. is on its way to oil independence and the rest of the world is experiencing muted economic growth. Oil demand is relatively inelastic in the short term, meaning that countries and individuals will both buy relatively the same amount, regardless of the price. This means that, if Canada exports a given amount of oil per year, as the price falls, it will simply be receiving less money for the same number of barrels of product. The increase in amount of oil exported due to the lower price will likely not be enough to offset the effect of the recent drop in oil prices. As a result of the cheaper oil, there will be less international demand for Canadian dollars, and thus there will be a downward pressure on the value of the Canadian dollar. Although the real effects of lower oil prices will take some time to actually affect the country fiscally, in the near term, the value of the currency is likely being driven down by speculators, who are using this forecast as justification for their speculation. In summary, as well as the factors listed above, oil prices are hugely influential on the value of the Canadian dollar; the recent drop in prices has been the catalyst behind the currency’s recent dip and until the fundamentals governing the price of oil change, it is unlikely that we will see an appreciation of the Canadian dollar.

 

 

 

 



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