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Factors Influencing Exchange Rates

The determination of Exchange Rates

Some of the news headlines Mon, Sep 10, 2012 at 17:26

Rupee edges down, oil-related dollar demand hurts

The rupee weakened on Monday on account of dollar demand from oil refiners, but further losses were averted on hopes of more monetary stimulus by the Federal Reserve following weak non-farm payroll (NFP) data in the U.S. on Friday.

MUMBAI, September 10, 2012

Rupee down 8 paise at 55.44 on dollar demand from importers

The rupee today snapped its two-day upward movement and dropped by 8 paise to close at 55.44 on fresh US dollar demand from importers.

Capital inflows worth Rs 600 crore in stocks, however, helped cushion rupee from a sharper fall, forex dealers said.

The rupee commenced on a strong note at 55.26 a dollar against last weekend’s close of 55.36 at the Interbank Foreign Exchange (Forex) market.

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MUMBAI, FRIDAY JAN 18, 2013: 

Forex reserves up by $1.26 billion The country’s foreign exchange reserves rose by $1.26 billion to

$295.25 billion for the week ended January 11, on the back of sharp rise in currency assets, the Reserve Bank of India (RBI) said today.

The total reserves had slipped by $1.59 billion to $294.99 billion in the previous reporting week.

Foreign currency assets, a major component of the forex reserves, were up by $1.214 billion to $262.276 billion for the week ended January 11, the RBI said in its weekly statistical supplement.

After plummeting in the previous reporting week, gold reserves remained unchanged at $27.22 billion, the apex bank said.

For the week under review, the special drawing rights (SDRs) were up by $31.3 million to $4.433 billion, while the country’s reserve position with the IMF rose by $16.5 million to $2.324 billion.

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Terms used to refer to currency changes

A “Devaluation” refers to a decrease in the stated par value of a pegged currency, one whose value is set by the government; an increase in the par value is known as “Revaluation”.

In contrast, a floating currency whose value is primarily set by the market forces is said to “Depreciate” if it loses value and “Appreciate” if it gains value against other currencies.

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Factors influencing exchange rate

There are two methods of analysis used in the studying and forecasting of the exchange rate movements. Technical Analysis Fundamental Analysis

The Technical Analysis is used for short-term forecasts. It uses the past data and trends in it.

The methodology includes tracing graphs and charts formed by exchange rate movements and anticipate the changes based on the patterns formed earlier.

This method is based on the belief that history repeats itself.

Factors influencing exchange rate

The Fundamental Analysis is a long-term assessment of the rates based on the changes in the fundamentals of the economy or macro economic factors.

The rate of exchange is the outcome of the combined effect of multiple factors constantly at play:

1.Balance of Payments 2.Inflation3. Interest Rates 4. Money Supply5. National Income 6. Resource Discoveries7. Capital Movements 8. Political Factors9. Psychological factors & 10. Market factors Speculation

In the short run (during the trading day) it is the demand and supply of the foreign currency is the most influencing factor of the exchange rate. The situation arises out of the supply of the foreign currency by the exports or other inward remittances while the demand comes from the import or other remittances out of the country.

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Balance of Payments Exporters offer to the market foreign currency they have acquired in

exchange for local currency. Conversely, imports into the country will increase the demand for foreign currency while increasing the supply of local currency.

When the BOP of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply (or alternatively demand for foreign currency is higher than its supply). Therefore, the value of the local currency declines increasing the value of foreign currency.

If the BOP is surplus continuously, it shows that the demand for the local currency in the exchange market is higher than its supply and therefore the local currency gains in value & foreign currency loses value.

Inflation Inflation in the country would increase the domestic prices of the

commodities. This will lead to reduction in exports as the prices are not competitive.

With decrease in exports, the demand for the local currency would also decline which would result in reduction in the external value of the currency.

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The relative rate of inflation in two countries is what causes changes in the exchange rates. For ex: if both India and USA experience 10%inflation, the exchange rate between rupee and dollar will remain the same.

If the inflation in India raises to 15% and in USA remains at 10%, the increase in prices would be higher in India than it is in USA. Therefore, the rupee will depreciate in value relative to the dollar.

Relative Interest Rates Interest rate has significant influence on short-term movement of capital.

This would increase the demand for the currency at the centre where the interest rate is higher and hence its value.

Raising of interest rate due to tight money conditions or as a deliberate attempt to attract foreign investment may result in strengthening of the currency of the country.

A higher interest rate differential will attract larger inflow of investment and reduction in the outflow. However, it should be unilateral and unaccompanied by similar changes in other countries.

Example: A rise in the US interest rates relative to Euro rates, all else being equal will cause investors in both countries to switch from Euro to Dollar denominated securities. The result will be depreciation of the Euro in the absence of any governmental intervention.

The interest rates referred are real interest rates which is equal to the nominal/actual interest rate minus the rate of inflation.

The distinction is quite critical in international trade. If the increase in the US interest rate relative to the Euro interest rate reflects higher US inflation, the result will be a weaker dollar.

Money Supply The total money supply in the country represents the value of

commodities and services in the country which has an impact on the purchasing power of the currency and hence the external value of the currency.

The effect of money supply on exchange rate directly is more immediate than its effect through inflation.

While in the long run inflation seems to correlate exchange rate variations in a better way, in the short run exchange rates move more in sympathy with changes in money supply.

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National Income Increase in the national income reflects increase in the income of the

residents of the country. This will lead to increase in the demand for the goods in the country.

This situation will lead to increase in the production and/or increase in imports leading to increase in the supply of local currency in the foreign exchange market.

This has the effect similar to that of inflation viz. decline in the value of the currency. It is the relative increase in national income of the countries concerned than the absolute increase.

Resource Discoveries History has several instances of currency gaining in value due to

discovery of key resources such as oil. In times of oil crisis due to poor supplies has favoured countries like USA, Canada, UK and adversely affected countries such as Germany and Japan who depend on imports.

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Capital Movements Apart from the movement of currencies due to interest rate

differential, favourable investment climate and political stability will encourage portfolio investments in the country. This will lead to higher demand for the local currency leading to upward trend in its rate.

Poor economic outlook may mean repatriation of the investments leading to decreased demand and lower exchange value for the currency of the country.

Psychological factors and speculation In the short run, the exchange rate is affected mostly by the views of

the participants in the market about the likely changes in the exchange market. These expectations may be based on one or more of the factors already listed above.

Whenever there is discrepancy between the previously held expectations and the actual outcome will lead to temporary movement

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Speculation exerts powerful influence on exchange rates, sometimes aggravating the trend set by other factors. A large scale purchase or sale of currency with the expectation of rise or fall in the exchange rates will further accelerate the fall or rise.

Speculators taking position in currency prior to announcement of important indices like Housing Starts, Job data, consumer confidence index etc., influence the currency either way depending on the expectations and the actual outcome.

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Political factors Any change in the government or political leadership or policies of

the government will have the effect of temporarily affecting the smooth operations of the exchange rate mechanism.

The economic policies adopted by the government have great influence on the exchange rates. The major instruments used by the governments – the monetary and fiscal policies have effects on the inflation, interest rates etc., which have a bearing on the exchange rates.

Official interventions will have the effect of smoothening the rate in a disorderly or volatile market. However, attempts to counter the market’s anticipation and resist by intervention may ultimately lead to steep and sudden exchange rates, if the intervention is withdrawn.

Market factors Isolated large transactions in the market may upset the market’s

ability to balance the supply and demand for the currency in the spot market. For ex; large oil remittances for imports may drive the foreign currency up if there is not adequate supply to meet the demand for the currency.

The situation will continue till the amount is fully absorbed in the market and normalcy is restored.

Thus exchange rates are influenced by several factors. While some of them are interrelated some are independent and together affect the currency movement.

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Forex traders …

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Forex traders…

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Forex traders…

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