10 Factors Affecting Foreign Exchange Rates

Imagine this: You’re planning a long family trip to Scotland, excited about exploring the beautiful sites. You’ve carefully planned your whole itinerary, packed your bags, and found all the places your family will love eating. However, through this,  you forgot to convert your currencies from Euros to GBP.  The next day, you get time to check the exchange rates and convert your money. But to your shock, your travel budget is now 500 GBP higher than what you had initially calculated.

Surprising, right?

That’s what you call currency fluctuation!

Currency fluctuation is a result of factors that cause variations in currency exchange rates. Simply put, the Currency Exchange rate is the rate at which one currency is exchanged for another. 

What triggers Currency Fluctuation?

There are plenty of factors that contribute to currency rates, and changes in any one of them can lead to volatility in the market and ultimately affect your currency transaction. Here are 11 factors that can affect the currency exchange rates: 

Interest Rates

Central banks and governments use interest rates as strategic tools in monetary policies to control inflation and currency exchange rates. The determination of interest rates is influenced by various factors, such as local political influence, economic health, and the country’s global exposure. The effect of interest rates on currency can be seen in the US 2008 financial crisis. 

The tremble of the 2008 financial crisis led the US Federal Reserve to set interest rates at their lowest to stimulate the economy.  When the economy showed stability, the Fed started raising the interest rate, urging foreign investors to invest more. The higher investment increased the demand and price of the US dollar in the currency market.

Inflation Rates

The inflation rate can be defined as the price rise in similar goods or services over a stipulated period. Higher inflation depletes the purchasing power of citizens and businesses in foreign markets. To control inflation, banks raise interest rates to limit people’s spending. The Central Bank of Argentina adopted the same method and constraints, such as capital controls, to influence the foreign currency flow.

From 2018 to 2019, Argentina underwent multiple episodes of high inflation, where the inflation rates skyrocketed above 50%. The currency rates were 18 ARS/USD in January 2018, which drowned by 70% resulting in 60 ARS/USD in December 2019.  The drastic currency falls shook the confidence of investors and caused the withdrawal of foreign capital, provoking economic disturbance in Argentina.

Political Stability and Economic Performance

The political instability or distressed environment within the country can constrain the flow of the country’s international investments. Unstable political stands lead to the deterioration of the country’s economic health, hence, the rise in inflation, unemployment rates, and drowns down the growth. Apart from financial stability, a risk inherited from the investment inclines the investors to shift their investment to safe countries and a better economy.

One of the finest examples of political instability and currency depreciation is the Brexit referendum results, where the UK voted to leave the European Union (EU). Due to this,  GBP fell snappily against the US Dollar (USD). The GBP/USD exchange rate dropped from around 1.50 to 1.32 in a single day, a decline of over 12%. It has influenced not only currency but also the political landscape and economic growth.

Public Debt

The public or government debt is the amount owed by the government for the funds borrowed to conceal expenditures. In simpler words, when the government’s credit surpasses its revenue, it must take in money from other international institutions. So, when a country borrows money or sells its securities like bonds, it increases the supply of the local currency in the currency market, triggering a reduction in its price. 

In early 2010, Italy, one of the Eurozone’s largest economies, crumbled into an economic crisis due to sovereign debt. Italy’s public debt was high over the years, reaching 120% of the GDP in 2011, resulting in the euro falling against the US dollar and other major currencies as fears about the stability of the Eurozone intensified. 

Terms of Trade

The Terms of Trade denote the ratio of a country’s import and export prices. Simply put, the Terms of Trade equal the country’s total exports minus total imports. High TOT indicates the demand for the country’s exports, leading to demand for the local currency in the currency market at better prices. The TOT of South Africa felt a sharp rise during 2010-2011 due to the high demand for minerals such as gold and platinum as the world recovered from a global financial crisis. A high surge in mineral prices improved the ZAR/USD exchange rate, which grew from around 7.60 to 6.70. 

However, after the 2011 spike, the world had a higher supply of minerals and lower demand, which worsened South Africa’s TOT. From mid-2011 to early 2013, the ZAR/USD exchange rate fell from around 6.70 to 9.50, a decline of approximately 42%.

Speculation

Currency Speculation reflects the trader’s sentiments over an exchange deal. For example, if a spectator feels that the price of GBP will fall relative to the Euro in the future, they will start selling the Euro and buy GBP. When a community or group of traders start acting in a certain way, it brings a wave of thunder to make one currency strong and the other weak in the market.  The stagnant impact of the speculations and emotional behaviours of the traders can be seen in the Swiss Franc (CHF) and the Unpegging from the Euro (2015). 

The sudden surprise and fear of losing impel people to transact with speculations, and CHF surged by nearly 30% against the EUR within minutes. 

Economic Recession

Economic Recession results from the shrinkage of the economic indicators impacting the country’s monetary health. The wake-up call for the recession can be defined by lower GDP, higher inflation, lower household income, and rising unemployment rates. One of the classic examples of the economic slowdown is the Eurozone Debt Crisis (2010-2012), which began with the crash of Iceland’s banking system and quickly spread to Greece, Ireland, Portugal, Spain, and Cyprus. While the EUR/USD exchange rate fluctuated between 1.20 and 1.35 from 2010 to 2012, safe haven currencies like the US Dollar (USD) and the Swiss Franc (CHF) were highly appreciated as investors started moving their investments from the Euro to other currencies. 

Differences in Market Growth

The various states of the economy have different impacts on the currency markets. A stable economy, higher GDP and better economic growth will delight investors as they seek better returns. Higher foreign investments mean higher demand for the local currency and better prices. However, the lower growth in developing countries with unsafe investment opportunities can lower the currency demand and price immediately. The best example of economic growth is the Brazilian Real.  During the early 2000s, Brazil experienced elevated economic growth due to a commodities boom, which led to an appreciation of the Brazilian Real (BRL). However, when growth slowed, the BRL declined significantly.

Government Intervention

The government and its associated authorities, like Central Banks, manipulate the currency markets by controlling interest rates and inflation within the country. The prime functions of the central bank are to create the monetary policies that can stimulate the economy, and peg their currency to another with the intent to stabilise the local currency rates.  The famous examples of the government intervening in the forex markets are the European Central Bank (ECB) and the Federal Reserve (Fed). Both authorities played their part well through the strategic implementation of monetary sovereignty. 

The European Central Bank (ECB) lowered interest rates to stabilise the economy, turning away foreign investments, which depreciated the prices of the Euro. While the Fed’s decision to raise interest rates after the recovery of the economy led to an appreciation in the price of the USD.  

Global Events

The currency exchange isn’t limited to one territory, so whenever a significant global event takes place, it gets affected by the scale of the event. A recent example of this was the General Elections held in the UK, leaving a major impact on the Euro rate. There are other factors, such as elections, conflicts, natural disasters,  or policy changes, that can result in volatility in the open foreign exchange markets. The COVID-19 pandemic is one of the major indicators of the unprecedented economic disruption at the global level. The uncertainty and economic downturn caused by such occasions can result in capital flight to safer assets. Another example is the US-China Trade War, which created fluctuations in the USD and CNY while influencing investor sentiment and trade balances at a global level. 

Conclusion

Foreign exchange rates are shaped by a complex interaction of both domestic and international factors, which include economic indicators like interest and inflation rates, as well as global occurrences such as political unrest and pandemics. Recognising these factors is essential, not only for businesses involved in international trade but also for travellers, investors, and policymakers.

As we’ve observed, currency values can change rapidly due to speculation, government actions, or unexpected crises. Whether it’s a construction firm handling cross-border payments or a family planning a vacation abroad, understanding the elements that influence exchange rate variations can help prevent surprises and enable more informed financial choices.

By keeping updated and seeking expert advice when necessary, you can approach the currency markets with greater confidence and protect your financial strategies, regardless of where your travels may lead you.