What are the factors that affect a country's currency?

Factors that influence exchange rates

• Inflation

If inflation is relatively lower in a country than elsewhere, then exports will become more competitive, and there will be an increase in demand for local currency to buy those goods. Also, foreign goods will be less competitive and so citizens will buy fewer imports. Therefore, countries with lower inflation rates are predisposed to appreciation in the value of their currency.

• Interest rates

It is said that hot-money-flows to the country with higher interest rates. In other words when interest rates rise relative to elsewhere, it will become more attractive to deposit money in this particular country. As a result, demand for local currency will rise and it is known as “hot money flows”, which becomes an important short-run factor in determining the value of this currency.

• Variations in competitiveness

If goods become more attractive and competitive it will influence the value of the exchange to a higher value. If a sampled country had a long-term improvement in labor relations and higher productivity, its goods will become more competitive in international markets which will cause a long-run appreciation in the local currency.

• Strength of other currencies

In the first decade of 2000 when the value of the Japanese Yen and Swiss Franc rose because markets were worried about other major economies, particularly the US and the EU. Moreover, despite low-interest rates and low growth in Japan, the Yen kept appreciating. In opposite direction the UK pound fell to the dollar In the mid-1980′s, mostly because the strengthening of the dollar, was provoked by increased interest rates in the US.

• National accounting and balance of payments

A deficit on the current account is simply that the value of imports is greater than the value of exports. If this is financed by a surplus on the financial/capital account, then it won’t make much difference. However, a country that has troubled attracting enough capital inflows to finance a current account deficit will see depreciation in its currency. For example, a current account deficit in US of (X)% of GDP will depreciate the dollar but at the same time makes exports more competitive in global markets.

• Government debt

Government debt can influence the exchange rate in the currency market under various circumstances. If markets are alarmed that a government may default on its debt, investors will sell their bonds initiating a fall in the value of the exchange rate. Iceland and Argentina are good examples of debt problems attributed to excessive printing of money.

The Trump administration with its passage of tax reform includes printing money for about $2 trillion dollars on top of the already bulging debt of $19.8 trillion with a large percentage held by Japan and China. These numbers render a ratio of 106% of GDP to Debt which means that the government is printing more money than the economy is producing in value. If markets feared the US would default on its debt—as Trump hinted during the election cycle— investors will panic and sell their holdings of US bonds. This would cause a precipitous fall in the value of the dollar with unknown consequences because the enormous size of the US economy compared to the rest of the world at $19.3 trillion in 2017. Total US net worth reached $93 trillion in Q4 2016.

• Government intervention

Many governments attempt to influence the value of their currency buying a reserve currency in order to undervalue the local currency making exports more price competitive in the global market. In a recession a country might raise interest rates to attract investment for a recession that might cause depreciation in the exchange rate.

• Currency speculation

For a small country-economy this is probably the most feared currency manipulation by speculators. If a country’s currency is believe will rise in the future, investors will demand more in order to make a future profit. This increase in demand will cause the value of this currency to rise. These movements in the exchange rate do not always reflect the economic fundamentals of a country but are often driven by the views of the financial markets.

Countries often use quantitative easing (increasing the money supply or printing more money) but this only works if country’s currency is considered a money reserve in the basket of world currencies.

Speculative attacks occur on a currency when speculators believe the value of a currency is over-stated and therefore, they sell that currency in anticipation of it falling and buy another currency. Other speculation methods include engagement in ‘short selling’. This happens when an investor sells assets (Currency) that he/she doesn’t own, and agrees to repurchase them at a future date. If the currency falls in value, then they make a profit, because they sold currency at a high price, but can repurchase at a lower price.

• Semi-Fixed Exchange Rate Speculation

Speculation in a semi-fixed exchange rate is most likely to occur, if a government is committed to keeping the value of a currency at a particular exchange level. If the economic situation deteriorated, the worth of the currency most likely will drop in a floating exchange rate. If the government were committed to keeping the value of the exchange they would have to commit their foreign exchange reserves to buy the local currency on the exchange markets, increase interest rates to make it more attractive to save money in the local currency to keep savers at home.

However, speculators may feel that a government is unable to keep the value of the currency at that level in the long term. Speculators depend precisely on that economic situation to make a profit because:

• Higher interest rates in a local market are unsustainable because depresses demand provokes unemployment and therefore is counterproductive. Governments only have limited amounts of foreign exchange reserves to keep buying their own currency and must enter currency markets in order to keep buying. But, as the government is committed to keeping the value of its currency, speculators will be happy to sell their local currency holdings in exchange for a reserve currency this government is willing to sell at a fixed rate.
• Soon the government will realized that to keep its currency value is unrealistic and will have to accept devaluation. The value of the currency will fall. Then, speculators who bought with local currency reserve currency will realize an increase in wealth. The weaker or smaller the targeted economy by speculators the easier it is to provoke devaluations specially, when a government instead of choosing fundamentals as its reference for “floating” its currency and pegging it to an exchange rate becomes matter of pride set in the wrong place.