Currency fluctuations are a natural result of most major economies’ use of variable exchange rates. A country’s economic performance, inflation expectations, interest rate differentials, capital flows, and other factors all influence exchange rates. The strength or weakness of the underlying economy usually determines the exchange rate of a currency.
As a result, the value of a currency might fluctuate from one moment to the next.
Many people are unconcerned about exchange rates because they are rarely necessary. The average person’s daily activities are undertaken in their own currency. Exchange rates are only relevant for a few transactions, such as international travel, import payments, or international remittances.
A strong home currency might appeal to a foreign traveler because it would make travel to Europe more affordable. However, a strong currency can have a long-term negative impact on the economy, rendering entire industries uncompetitive and resulting in the loss of thousands of jobs.
While some people desire a strong currency, a weak currency can provide more economic advantages.
When it comes to monetary policy, central banks take the value of the native currency in the foreign exchange market into account. Currency levels may influence your mortgage interest rate, your investment portfolio returns, the price of food at your local supermarket, and even your job prospects, either directly or indirectly.
The Economic Impact of Currency
The value of a currency has the following direct effects on the economy:
Trade in Merchandise
This is the sum of a country’s imports and exports. In general, a weaker currency increases the cost of imports while increasing exports by making them more affordable to foreign buyers. Over time, a weak or strong currency can contribute to a country’s trade deficit or surplus.
Assume you’re a U.S. exporter who sells widgets to a European client for $10 each. €1=$1.25 is the current exchange rate. As a result, your European buyer will pay €8 each widget.
Capital Flows
Countries with strong governments, active economies, and stable currencies attract foreign money. To attract cash from overseas investors, a country requires a somewhat stable currency. Otherwise, the threat of currency depreciation-induced exchange rate losses may dissuade foreign investors.
Foreign direct investment (FDI), in which foreign investors buy, sell, and trade securities in the recipient market, and foreign portfolio investment, in which foreign investors buy, sell, and trade securities in the recipient market, are the two types of capital flows. For developing economies like China and India, FDI is a key source of funding.
Inflation
For countries that import a lot, a depreciated currency might result in “imported” inflation. A 20% drop in the home currency could result in imports costing 25% more, as a 20% drop requires a 25% rise to return to the former price point.
Interest Rates
As previously stated, most central banks evaluate exchange rates while determining monetary policy. Mark Carney, the governor of the Bank of Canada, stated in September 2012 that the bank took the persistent strength of the Canadian dollar into account when determining monetary policy. The strength of the Canadian dollar, according to Carney, is one of the reasons why his country’s monetary policy has been “exceptionally accommodating” for so long.
A strong domestic currency drags the economy down, producing the same effect as tighter monetary policy (i.e. higher interest rates). Furthermore, greater monetary tightening at a time when the domestic currency is already strong may compound the problem by attracting hot money from foreign investors seeking higher-yielding investments (which would further strengthen the domestic currency).
Examples of Currencies’ Global Impact
The forex market is the world’s most actively traded market, with daily trades reaching $5 trillion, considerably exceeding global equities. Despite their massive trade volumes, currencies are rarely featured on the front pages of newspapers.
There are occasions, though, when currencies fluctuate dramatically and the effects are felt all around the world. A few instances are provided below:
- The 1997-98 Asian Crisis
- China’s Yuan Is Undervalued
- From 2008 to 2013, the Japanese Yen fluctuated.
- Euro Concerns (2010-12)
What Are the Benefits to an Investor?
Here are some ideas for profiting from currency movements:
- Invest Abroad
- Invest in America Multinationals
- Currency Risk Hedging
- Avoid borrowing in foreign currencies with low interest rates.
Thoughts
Currency movements can have a large impact on a domestic economy as well as globally. When the dollar is weak, investors might profit by investing overseas or in global companies based in the United States.
When one has a substantial forex exposure, currency changes can be a significant risk, hence it may be preferable to offset this risk using one of the many hedging instruments available.
