By Phillip Silitschanu
In life, we fear that which we do not know. Knowing, and more importantly understanding, which direction foreign exchange rates are moving is the key to preventing the costly error of trading currencies at the wrong time.
Understanding what factors affect an exchange rate can sometimes seem like a mysterious magic act. Exchange rates are nothing more than the price of a currency: just as you look at the price of a gallon of gasoline in U.S. dollars when you pull into the gas station to fill up, to see if it has gone up or down, you can look at the price of a foreign currency (in the form on an exchange rate) to see if its price has risen or fallen in dollars. Just as the price of a gallon of gasoline rises and falls because of supply and demand, the supply and demand is affected by factors in the world, such as international trade, which uses petroleum to power ships, trains, and airplanes. Political events can also make it difficult to export or import oil from certain countries, along with general economic news that affects the amount of petroleum (and gasoline) used. In the same way, exchange rates are affected by key economic indicators, such as changes in capital markets, international trade, political events, and economic news.
The movements of capital markets in various countries are a broad indicator of potential changes in exchange rates. Changes in a country’s capital markets can influence the value of its currency, which is reflected in its exchange rate. A country’s debt and equity markets anticipate the changes to broader economic indicators within the country, as the value of the securities in the markets are based on the fortunes or failures of the companies in the country, which are in turn based on the health of their sales revenue.
Exchange rates often very closely follow the fortunes of a country’s international trade. A country’s international trade balances reflect the inflows and outflows of goods and services (their international trade). When a country has a trade deficit, that country is a net importer of goods and services from other countries , therefore more of the local currency will be sold in order to pay for those goods and services, usually causing the currency’s exchange rate to trend lower. This is a reflection of basic supply and demand: more businesses and people in a country “give away” their currency in exchange for goods and services from foreign countries. As they give away their currency for foreign goods and services, this creates a surplus of their currency. This surplus acts on the exchange rate to push it lower. For example, early in the 21st century, the United States faced an enormous trade deficit ($488 billion in 2002), and saw its currency drop by over 9% between February 2002 and July 2003.
On the other hand, a trade surplus causes the exchange rate to increase: as foreign buyers seek to purchase the products and services being offered by the businesses in the country, those foreign buyers seek to purchase that country’s currency, increasing its scarcity and its price.
The policies a country’s government implements can have a significant effect on a currency’s exchange rate. As policies promote or suppress certain parts of a country’s economy, those changes can affect how desirable its currency is, in turn affecting the currency’s exchange rate. For example: a country implements policies which offer government subsidies, or lower tax rates , for an industry such as aircraft manufacturing. Foreign airlines purchase that country’s manufacturer’s aircraft, meaning those purchasers need that country’s currency. In Europe, for example, European governments paid 100% of the development costs for the research and development of the first Airbus aircraft, and even today Airbus receives nearly interest-free government loans.
Government policy also affects a currency’s exchange rate in other ways: elections, policy changes, and the balance of power of political parties can change the direction of a country’s economy. As the economy increases or decreases, so does the currency’s exchange rate. Central banks can also influence the currency’s exchanger rate: as they adjust interest rates up and down, the exchange rate is also affected. A higher interest rate in a country can lead to the currency rising in value, as foreign investors seek to invest their money in the country’s debt, requiring that they purchase that country’s currency.
Economic releases, such as releases of statistical information by a country’s government agencies, also have an affect on exchange rates. Some of the most widely referenced economic releases (also referred to as economic indicators) are a country’s Gross Domestic Product (GDP), inflation rates, unemployment data, manufacturing indices, retail and consumer goods sales figures, new home construction figures, and lending data. Ideally, positive data generally will lead to a more desirable currency, leading to a higher exchange rate. This is not always true, as sometimes contradicting data can cause concerns of an impending imbalance in a country’s economy, with changes to the exchange rate following soon thereafter.
The monitoring of basic economic indicators supports companies in forecasting and intelligently planning currency transactions to take advantage of favorable currency exchange rates.
Phillip Silitschanu is the founder of Lightship Strategies Consulting LLC, and CustomWhitePapers.com. Phillip has nearly 20 years as a thought leader and strategy consultant in global capital markets and financial services, and has authored numerous market analysis reports, as well as co-authoring Multi-Manager Funds: Long Only Strategies. He has also been quoted in the U.S. Financial Times, Wall Street Journal, Barron's, BusinessWeek, CNBC, and numerous other publications. Phillip holds a B.S.in finance from Boston University, a J.D. in law from Stetson University College of Law, and an M.B.A. from Babson College.