Monday, November 17, 2008

What Factors Influence The Level Of Exchange Rate?

What influences exchange rate?

(1) Balance of payments (BOP) deficit. When a country has large BOP deficit, it is likely caused by the huge deficit for trade in goods under current account. This means imports are greater than exports, causing large outflow of home currency. If this is offset by the large inflow in capital account/ financial account, then it should be fine. But for some countries which find difficulty to attract sufficient inflow of hot money, this could be a problem. There will be no balance between the two then

US & UK are two excellent examples. US current account deficit is about 6-7% of its GDP while UK’s 5%. In theory, dollar & pound should have fallen much given the large deficit in their current account. But since their capital account is equally resilient, therefore this had somehow helped to prevent the value from going down much

(2) Strength of other currency. The strength of pound depends much on other factors which are out of control. For instance, UK economy slowdown. When investors realise that prospect of earning good return on assets in UK is getting dim, they will pull out their investment. Many of these foreign investors are from US & other emerging economies. When they fled pound denominated assets, pound will begin to depreciate against many other foreign currencies. Even when US & whole world economy is slowing down, people will still want to hold dollar as US is perceived as the largest yet most stable economy

Other factors like the end of yen-carry trade activities. Yen-carry trade is a term referring to investors (including Japanese) who borrow in yen to invest in other countries that give better returns. This is because borrowing in yen is so cheap. So, investors would like to take advantage of the differential in interest rates. Much of these went to US, Eurozone & UK. Since the developed economies had slashed interest rates that much, investors pulled out their money & return to home country. That also partly explain why several weeks ago, yen appreciated much against dollar

(3) Speculation activities. If investors believe that pound will be a stronger currency in future, they will want to hold pound now to make profit. Therefore the demand for it will increase, causing it to appreciate. Have a look at it, one can tell that this is not more than a ‘self-fulfilling prophecy’. Therefore movements of exchange rate does not necessarily reflect economic fundamental, but rather the herd mentality in the financial market

Source of diagram: BBC

(4) Interest rates. When a country with relatively strong currency begins to offer higher interest rates such as UK, there will be large inflow of hot money. These come from wealthy foreigners, large institutional investors, hedge funds etc. In order to place monies in UK, they will need to supply their home currency in order to buy pound. As demand for pound surge, it will appreciate. These also helps to explain why pound is so strong before the financial crisis, especially when the interest rates was at 5.75% somewhere September last year

(5) Level of inflation. If inflation in UK is lower than elsewhere, generally goods manufactured in UK will be more competitive, since it is relatively cheaper. Therefore demand for UK exported goods will increase, & this means appreciation of pound. On the other hand, Britons may find that foreign goods are not competitive & therefore supplying lesser pound. Therefore pound will appreciate say from $1.90 for £1 to $2.00 for £1

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