Determinants of Currency Exchange Rates Part-I

Foreign Currency Rates

Foreign currency rates are determined by a variety of factors and discussing those key factors that
affect currency exchange rates e.g., dollar to PKR. They are connected to the trading relationship
between the trading partners. Remember that foreign currency rates are a
relative term that describes the value of one currency concerning another.
Before looking deeper into the reasons for currency depreciation or appreciation, it is necessary to consider the consequences of international
capital flows. When foreign financing available to countries abruptly
disappears, this phenomenon is described in the economic literature as a
“sudden stop,” in which countries are forced to undergo potentially
painful resource transfers to creditor countries. When this occurs, an
outstanding current account deficit that was previously financed through foreign
capital inflows must be eliminated or financed through international reserve
losses. Experience has shown that developing countries, as opposed to developed
countries, are experiencing abrupt declines.

Sudden Halts and Capital Flows

Sudden halts in
gross capital flows are linked to financial instability, particularly when the
gross flows are dominated by volatile cross-border banking flows. Sudden halts
in gross and net capital flows are examples of externally triggered episodes.
This implies that the spark that ignites sudden stops comes from outside the
affected country: specifically, the supply of foreign financing, which can halt
for reasons unrelated to the affected country’s domestic conditions. However,
unless combustible materials are present, a spark cannot start a fire.
According to the literature, a set of domestic macroeconomic fundamentals is
the combustible material that makes some countries more vulnerable than others.
Higher fiscal deficits, larger current account deficits, and higher levels of
foreign currency debt in the domestic financial system are symptoms of weak
fundamentals that increase vulnerability. When the crisis occurs, these same
factors raise the costs in terms of output losses. On the other hand,
international reserves act as buffers, allowing countries to mitigate risks.
Holding foreign currency reserves protects the government’s fiscal position,
giving it more resources to respond to the crisis. While it may be impossible
for countries to completely protect themselves from the volatility of capital
inflows, the choice of antidotes to prevent that volatility from forcing
potentially costly external adjustments is entirely in their hands. The global
financial architecture can be strengthened to support those efforts if
countries agree on and fund a more powerful international lender of last
resort, similar to the role of the Federal Reserve Bank in promoting financial
stability in the United States on a global scale.

Foreign investors can cause sudden stops by reducing or stopping
capital inflows into an economy, and/or domestic residents can cause capital
outflows by withdrawing their money from the domestic economy. Because abrupt
stops are typically preceded by robust expansions that drive asset prices
significantly higher, their occurrence can have a significant negative impact
on the economy and tip it into a recession. According
to the World Bank, sudden stops have both financial and real assets
consequences. The first to manifest the financial effects: the currency exchange
rates fall, reserves fall, and equity prices fall. GDP growth then slows,
investment slows, and the current account improves. GDP growth falls by roughly
4% year on year in the first four quarters of a sudden halt.

Before delving
into these forces, we should consider how foreign currency rates movements
affect a country’s trading relationships with other countries. In foreign
markets, a higher currency value makes a country’s exports more expensive and
imports cheaper; a lower currency value makes a country’s exports cheaper and
imports more expensive. Higher foreign currency rates are likely to reduce the
country’s trade balance. whereas a lower exchange rate would raise it.

Determinants of Foreign currency rates

Foreign currency rates are determined by a variety of factors, all of which are related to the
countries’ trading relationships with their trading counterpart. The following
are some of the major determinants of a country’s exchange rate. It should be
noted that these factors are not in any particular order; the relative
importance of these factors, like many other aspects of economics, is widely
debated.

1.
DIFFERENTIALS IN INFLATION

In general, a
country with consistently lower inflation has a rising currency value, i.e.,
appreciation tendency. As a result of lower inflation, its purchasing power
grows in comparison to other currencies. Countries with higher inflation
typically see their currency depreciate with the currencies of their trading
partners. This is usually accompanied by an increase in interest rates. Why
does inflation have an impact on exchange rates? To comprehend inflation’s
negative effects on foreign currency rates, it is necessary to understand the
relationship between inflation and interest rates, as well as the relationship
between exchange rate and interest rate.

2.
DIFFERENTIALS IN INTEREST RATES

The most basic
explanation for inflation is that it reduces the purchasing power of money.
Assume there is 10% inflation and anything that can be purchased with Rs.100
today will require 100 x 1.1 = Rs.110 to purchase the same thing one year from
now. However, when we consider lending and borrowing, things become a little
more complicated. For the sake of simplicity, let’s say you have Rs 1,000 and
the price of a pizza is Rs 50 per piece, which means you can buy 20 pizzas with
Rs 1,000. Assume there is an investment opportunity that guarantees a 15%
annual return. In a year, your wealth will increase to Rs 1,150 (1,000 x 1.15)
in nominal terms, but in real terms, it will be less. Assume that the expected
inflation rate from now on is 10%; therefore, the price of pizza would be Rs
55/piece, implying that you can now buy 1,150/55 = 20.91 pizzas with this
amount of money. In reality, your wealth increased by 4.55 percent [(20.91 –
20)/20] rather than 15 percent. If you use the Irving Fisher formula (1 + R = (1+r)
x (1+ h), where R is the nominal interest rate, r is the real interest rate,
and h is the inflation rate, you will get the same 4.55 percent real interest
rate. When we try to understand the impact of inflation in the context of
international trade, things become more complicated. The theory of interest
rate parity attempts to explain the complex relationship between interest rates
and inflation. I explained it in the following paragraphs without using any
mathematical formulas.

Illustration Interest Rate Parity

Interest rates,
inflation, and currency exchange rates are all highly correlated with one
another. Central banks exert influence over both inflation and exchange rates
by manipulating interest rates, and changes in interest rates affect both
inflation and currency values. Higher interest rates provide lenders in an
economy with a higher return in comparison to other countries. As a result,
higher interest rates entice foreign capital, causing the exchange rate to
rise. However, the impact of higher interest rates is mitigated if inflation in
the country is significantly higher than in others, or if other factors serve
to drive the currency down. Lower interest rates tend to decrease foreign currency rates, whereas higher interest rates tend to increase them. To illustrate
interest rate parity, consider the case of a US investor who can buy a risk-free
90-day Pakistani’s T-Bill that promises a 7.3019 percent nominal return. The
90-day interest rate would be 7.3019% / 4 = 1.8255%. Assume also that the spot
exchange rate is $0.009416, which means that you can exchange 0.006269 dollars
for one PKR, or 159.5073 PKR per dollar. Finally, assume that the 90-day forward exchange rate is $0.009295, which means that you can exchange one PKR
for 0.006176 dollars, or receive 161.9157 PKR per dollar 90 days from now. The
US investors can receive a 7.3019 percent annualized return denominated in PKR,
however, if he or she ultimately wants to consume goods in the United States,
those PKR must be converted to dollars. The dollar return on the investment
depends, on what happens to the exchange rate in the next three months.
However, the investor can lock in the dollar return by selling the foreign
currency in the forward market. For example, the investor could simultaneously Convert
$1,000 to 159,507.30
PKR in the spot market and invest the 159,507.30 PKR in a 90-day Pakistani
T-Bill that has a 7.3019 percent annualized return or a 1.8255% quarterly
return. That will pay (159,507.30) x (1.08255) =162,419.11 PKR in 90 days. If
he agrees today to exchange these 162,419.11 PKR 90 days from now at the 90-day
forward exchange rate of 161.9157 PKR per dollar or for a total of $1,003.11. This
investment, therefore, has an expected 90-day return of [(1,003.11 – $1,000)/$1,000]
= 0.3109%, which translates into a nominal return to 4(0.3109%) = 1.24%. In
this case, 7.3019 percent of the expected 1.24 percent return is coming from
the bond itself and 6.0619 percent arises because the market believes the dollars to PKR
will strengthen relative to the PKR.

We know that dollar to PKR (USD / PKR) = 159.5073 in spot market (90-days Pak T-Bill rate is 7.3019%)

And USD / PKR =
161.9157 in forward market (13-week US T-Bill rate is 6%)

This is a standard
way to quote currencies, such as dollar to PKR (USD/PKR), where the numerator is the base
currency, and the denominator is the quote currency. It shows how much of the
quote currency is required to buy one unit of base currency. Using the above
information (and assuming that the US T-Bill rate remains constant because the
USD is a stable currency), and plugging it into the following formula, we can
estimate what the market expects the Pak T-Bill rate to be 90 days from now in
forward contract.

Quoted forward the rate indicates the market is anticipating inflationary pressure will persist in the
near future.

In the next
post, I will discuss other currency exchange rates theories with equally
significant factors like PPP, Current account deficit, fiscal deficit, term of
trade, and political stability, that influenced the exchange rate.