The most vital factor in foreign exchange is the determination of spot exchange rate. It is on this, all other activities revolve. We know that forward margin is determined by adding premium or subtraction discount with reference to spot rate. The spot exchange rate is not determined by a single factor. It is the combination of several factors which act either concurrently or independently in determining the spot rate. Let us discuss about these factors.
Balance of Payments
A study of International Trade and Consequent Balance of Payments between countries will determine the value of the currencies concerned. We know that in international trade exports from a country, both visible and invisible represent the supply side of foreign exchange. On the contrary, imports into a country, both visible and invisible create demand for foreign exchange. Let us illustrate with an example. Suppose India is making lot of exports to USA (both visible and also invisible). The Indian exporters have to receive ‘Rupee’ payment from USA and the importing merchants in USA would be offering lot of US dollars in exchange for rupees for payment to Indian merchants. Thus, there will be lot of supply of US dollars from the point of view of India and lost of demand for Indian rupees from the point of view of USA. Thus exports represent supply of Dollar demanding Rupees. When there is lot of supply of dollar, demanding rupees, the value of Rupee will automatically go up. On the other hand, if India imports more, we have to pay Dollars to USA merchants. This means, we will offer lot of Rupees, demanding Dollars. In that case, the value of Dollar will go up comparative to Rupees. In other words Put if differently, the exporters would offer foreign currencies in the exchange market, they have acquired, and demand local currency in exchange. Similarly, importers would offer local currency in exchange for foreign currency.
When a country is continuously importing more than what it exports to the other country, in the long run, the demand for the currency of the country importing would be lesser than its supply. This is an indication that the Balance of Payments of the country with reference to the other country is continuously at deficit. This will lead to decline of the value of the currency in relation to the other country. On the other hand if the balance of payments of a country is continuously at surplus, it is an indication that the demand for the currency in the market is higher than its supply and therefore the currency gains more value. Thus the value of the currency depends on balance of payment position.
Inflation in the Economy
Another important factor that would have serious effect on the value of currencies and the exchange rate is the level of inflation in the country. More inflation means increase in domestic prices of commodities. When commodities are priced at a higher level, exports would dwindle, as the price would not be competitive in the international market, and foreigners would not demand the commodities at a higher price. The decrease in the export, in the long run, would reduce the demand for the currency of the country and the external value of the currency would decline. Thus, if the country is under the grip of more inflation, the value of the currency will be low in the exchange market.
It should be understood in this context, that the value of the currencies concerned will depend on comparative inflationary rate in the two countries. Suppose the inflation in India is 20% and in USA also it 20%, the rate between dollar and rupee will remain the same. If inflation in India is higher than USA, the rupee will depreciate in value relative to dollar. Almost all countries of the world will be experiencing ‘inflation’ to a greater or lesser degrees. The inflation is a very vital factor in deciding the value of the currency.
The difference in interest rate between countries has great influence in the short term movement of capital between countries. If the interest rate in country ‘A’ increases, that country would attract short term of founds from other countries. This will create demand for the currency of the country having higher rate of interest. Ultimately, this will lead to increase in its exchange value. Raising the interest rate may also be adopted by a country deliberately to attract foreign investments to easen tight money conditions. This will increase the value of the currency. This is also an attempt to reduce the outflow of the country’s currency. But, this process may not sustain for long, if the other country also adopt similar measures of increasing the rate of interest. If country ‘B’ also increases the interest rate like that of country ‘A’, there will be no change in the exchange rate and the effect of country ‘A’ will be nullified
Money supply is also another factor affecting the rate of exchange between countries. As increased money supply will cause inflationary conditions in the economy and thereby affect the exchange rate via increase in price of exportable commodities. An increase in money supply should have scope for increasing production of goods in the economy. In other words, the increase in money supply should go hand-in-hand with increase in the production of goods in the economy. Otherwise, the increased money supply will be utilized in the purchase of foreign commodities and also making foreign investments. Thus the supply of the currency in the foreign market increases and the value declines. The downward pressure on the external value of the currency will in its turn increase the cost of imports and finally it adds to inflation in the economy.
Increase in National Income
Increase in national income of a country indicates an increase in the income of the residents of the country. This increase will naturally, create demand for goods in the country. If there is under-utilised productive capacity in the economy, this demand will lead to increase in production of goods. This will also lead to more export of goods. In some cases, this adjustment process will take a very long time; and in some other cases there will not be increased production at all. In such cases where the production does not increase in sympathy with income rise, it may lead to increased imports and also increased supply of the currency of the country in the foreign exchange market. This result is similar to that of inflation, i.e., decline in the value of the currency. Thus, increase in the national income may lead to increase in investment or in consumption and accordingly, it will have its effect on the exchange rate. Here also, this concept of increased national income is related to relative increase in national income between two countries and not the absolute increase in national income.
Discoveries of New Resources
A country in its progress of economic development, may also discover new resources which are very vital for the economy. These resources are called ‘Key Resources’ or ‘Basic Resources’ which would abundantly help the economy in the production of new goods and services and also in reducing the cost of production of existing goods and services. A country may discover Oil resources which are very vital for economic development.
Bright and congenial climate in a country combined with political stability will encourage portfolio investments in that country. In such cases, there will be very high demand for the currencies of those countries for purposes of movements. This higher demand will result in the increase of exchange rate of those currencies.
On the other hand, poor economic outlook, instantly, repatriation of investments etc. will result in the decreased demand for the currencies of those countries and as a result the exchange rate of those currencies will fall.
Speculation and Psychological Factors
The speculation may take the form of bull, i.e., purchasing heavily expecting a rise in price; or it may take the form of bear, i.e., selling heavily expecting a fall in price. It may also take the form of leads and lags, i.e., changing the time of settlement of debts with a view to getting advantage of the change in exchange rates. Arbitrage operations are also undertaken by the speculations to take advantage of difference in two markets. This will cause movements in exchange rates in both markets till a level is reached.
Finally, political stability of the country is of very vital factor. Investors will not be interested in countries which are ravaged with frequent wars or political rebellion. Frequent election, frequent change of government, frequent changes of policies of the government, lack of political will on the part of government etc., will detract the investors, and the currency of the country may not enjoy high value.
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