Variables that influence currency value
There are many variables that shape a country’s currency value. However, currencies much like any other tradable item are priced based on the laws of supply and demand. Here are some of the factors that impact the supply and demand.
Currency Supply – Central Banks
The supply side of the equation is usually controlled by a country’s central bank interest rates or increasing or decreasing the supply of money through open market operations. Central banks of countries with a developed economy will have targets for economic metrics they would like to achieve, such as inflation rate, employment levels, or GDP growth.
A good example of both of these techniques in practice was the European Central Bank response to the financial crisis of 2008-2009. By lowering interest rates, business and consumers were more likely to spend money rather than keep it in their bank accounts. Also, by buying assets in open market operations they injected currency into the market increasing the supply of total Euros. These both had the effect of driving the Euro down against most major economies.
Currency Demand – Many Factors
The demand side can be driven by policy changes, but it is also affected by external factors such as agents using the domestic currency to hedge against geopolitical risk, general increases or decreases in trade, making higher yielding investments, and future expectations of inflation and growth.
Resources & Trade
A resource rich country may see their currency appreciate in times of high demand for their resources. External agents need to buy the domestic currency to purchase the raw materials. The same would be true for a country with increased demand for the goods and services they create. This high external currency demand can then be linked to increased domestic inflation which may cause the central bank to step in and use measures to control the currency appreciation and inflation.
Canada is sometimes referred to as a ‘petro currency’ country given the correlation between the price of oil on world markets and the value of the loonie (CAD).
Investments and Stability
Chasing higher investment returns is another reason for currency appreciation. Consider one country offering Government bond yields much higher than another. The high yielding country may see their currency appreciate as investors buy it for investment in the high yielding investments.
Some currencies, such as the U.S dollar, have a history of being more stable than others even in times of economic uncertainty. Consequently, these reserve currencies remain in demand as preservations of wealth and maintain a higher value.
The intricacies of modern finance and economics present a near unlimited number of factors driving exchange rates making future predictions difficult. Consulting a Foreign Exchange Specialist can help make sense of the current and future exchange possibilities and can help mitigate possible risk.