Wednesday, 10 December 2008

How currency rates are determined

There was a time not so long ago when currencies were linked to gold. A typical bank note would say "I promise to pay the bearer the sum of $100 in Gold" or words to that effect.

All currencies were fixed in relation to other currencies and in relation to gold. Only central banks or governments were able to change the exchange rates between two currencies by means of devaluation or revaluation. Today the "gold standard" is history. Currencies themselves have no intrinsic value.

Sometime during 1970 under the guidance of market orientated economists, most Western countries decided to float their currencies. The market would determine the value of one currency against another. "Eastern Bloc" countries retained a fixed exchange rate. During the 1970's I visited the then communist Bulgaria. There were two exchange rates - one official, the other black-market.

In today's world, most currencies 'float'. The exchange rate between any two currencies fluctuates from day to day and throughout the day. The exchange rate at any point in time is determined by market forces. In countries where a fixed exchange rate is in force, a black-market for western currencies often emerges and flourishes reflecting a rate somewhat closer to the market forces.

A range of factors influence the exchange rate of any two currencies or the underlying supply and demand. These factors include:

The buying power of a currency compared to the buying power of another currency. This is known as Purchasing Power Parity or PPP. In theory, currency exchange rates fluctuate so as to achieve a state of equilibrium whereby the purchasing power of each currency become equivalent. If $2 = 1 on the foreign exchange market, then the buying power of $2 should equal the buying power of 1.

The rate of interest in each country is also important. An increase in the rate of interest in South Africa this month led to a strengthening of the local currency against the dollar. The higher interest rate makes investment in the country more attractive to foreign investors and increases demand for the currency.

The rate of inflation may affect the exchange rate. If country A has an inflation rate of 10% while country B has an inflation rate of 5%, then country A's currency should depreciate against country B's currency at 5% per annum.

The balance of payments. A current account deficit causes the central bank to hold large amounts of foreign currencies which reduces the value of the currency against that of other currencies.

The stability and strength of the economy and political situation are also important in determining the exchange rate. The currency of a country going through political turmoil will be weakened. If a country experiences a recession then its currency will also be affected.

Speculators may also play a part in influencing exchange rates especially of smaller economies where buying or selling huge volumes of the currency can have a marked if temporary impact on the rate of exchange.

None of these factors on their own determine the exchange rate. It is a complex mix of these and their effect on the perceptions of foreign exchange dealers and investors that will ultimately determine the rate.

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