As a human being, there are various ways you can check and assess your healthiness and well-being. There are plenty of physical indicators your doctor will look up including your blood pressure, pulse rate, blood work, and lots of others besides. When it comes to a country’s economic health, there are similar indicators that will give you a relatively good idea of how well the nation is doing. One of the surest and most useful measures of this is a country’s foreign exchange rate. This is simply the rate at which one country’s national currency may be exchanged for another’s, and is one of the most watched and analyzed metrics in the global financial and investment markets.
For individual investors in the stock markets, holders of various types of bonds, Forex traders, or general citizens or business people that want to send money abroad, it’s important to keep a keen eye on exchange rates. Let’s take a quick look at some of the factors that affect exchange rate levels for a better understanding of just what constitutes a healthy economy.
Every nation with its own currency has an institution in place that is tasked with the printing of currency and the formulation of government policy when it comes to money. This is usually referred to as the central bank. The central bank has the ability to either increase the supply of its currency on the market by printing more currency or decreasing its supply by buying it up and keeping it off the market.
A country that would want to keep its currency low in order to make its exports more attractive to foreign buyers (e.g. China) would buy up U.S. dollars, effectively reducing the supply of dollars in the market. The Chinese currency would therefore be relatively cheaper than the dollar, favouring Chinese exporters in trade terms.
The interest rates being offered in a particular country may be such that they offer the holders of various types of bonds higher returns than they would get elsewhere. Investors, being rational economic creatures, will seek to buy up this currency so that they may benefit from its strong performance. This will drive up its value in comparison to currencies that aren’t performing as strongly.
As you might expect, investors are attracted to countries with stable countries with minimal risk of political turmoil as investment destinations. As this foreign capital comes into a country, the local currency will grow in strength and vice versa.
Inflation may perhaps be the biggest contributor to a country’s exchange rate, perhaps because it may be considered a combination of various economic indicators. An economy with a low rate of inflation will experience slower increases in the pricing of goods and services within its borders, which is a highly desirable trait. This desirability will drive up its value in many areas, especially in the financial instrument scene where holders of various types of bonds will stand to gain much more value for their investment should a slow inflation rate be prevalent.
Where there is the opportunity to make a profit, the investors will come. Should it be expected that a currency will see again in value in future, for whatever reason, investors and traders will seek to take positions on it in the hopes of making a return when the anticipated event comes to pass.
Current Account Deficits
When countries trade between one another, they maintain a balance of accounts between them detailing imports, exports, debt, and so on. This is referred to as the balance of payments. Should a country be in a position where it spends more than it has come in, it will have a negative balance of payment, making it an unattractive foreign investment destination. This, as we’ve seen, subsequently leads to a weakening of the country’s currency.
Central banks have the authority to get into debt on a country’s behalf, and this debt is known as government debt or national debt. Just as it is in human society, countries with great amounts of foreign debt are less likely to receive foreign capital. This situation leads to inflation and the erosion of the currency’s value. A likely move by holders of various types of bonds in such scenarios is to sell off the bonds in order to minimize their losses, further debilitating and weakening the currency in question.
Andrew Cioffi is a marketing specialist and a writer. He lives with his wife and two children on the sunny shores of Australia, but dearly misses his home in the cold German north.