Monetary Policy

Most central banks are concerned with using monetary policy to manage the country’s inflation rate. Many banks (for instance, the European Central Bank and the Bank of England) have an explicit inflation target. In the broadest sense, the central bank will seek to maintain interest rates and inflation at a level that will permit the economy to grow at what is referred to as its “natural” or “trend” rate. Too fast a growt h rate can result in inflation, and the central bank will raise rates high enough to slow growth down, hopefully to bring about a “soft landing” with growth somewhat below trend for a while. If the economy is weak, with high unemployment, the central bank can allow rates to stay low enough to stimulate corporate and consumer borrowing, with the
expectation that inflation will remain relatively low. Thus, the level of interest rates powerfully affects a country’s business cycle, influencing inflation, unemployment levels and economic growth. Interest rates are used as signals by international investors on whether or at what time to invest, exchanging their currency for
the US dollar.

A high relative real rate is a strong positive for a currency. A tight monetary policy will affect real rates, boosting nominal yields higher versus expected inflation. The credibility of the monetary authority can be a powerful factor in how currency values relate to real interest rate differentials. If a country is believed to have the political will to maintain rates at the level necessary to deal successfully with inflation, then a relatively high real rate can lead to currency appreciation, as with Brazil in 2004 and 2005. On the other hand, if the market doubts the central bank’s effectiveness, high relative real rates may lead to currency depreciation, as happened in Indonesia, and other countries, during the 1997 crisis. In this case, the higher real rate represents
the higher risk premium demanded by investors for their expectations of a further currency decline.

Fiscal Policy

A government’s fiscal policy, or expectations about changes in government actions, can also affect currency value. A loose fiscal policy—tax cuts and/or increased spending—can lead to government deficits, and the government will need to borrow to finance them. This will cause bond rates to rise (other things equal), and higher real rates will cause the currency to strengthen. A loose fiscal policy also may indicate a higher economic growth rate in the future, which will attract investors and lead to a currency appreciation. Many argue that the increase in the deficit in the early Reagan years (1981 through 1985), with increased defense spending and large tax cuts, was the cause of the run-up in the dollar’s value in the early 1980s. Fiscal policy effects are not straightforward, however. A loose fiscal policy may “crowd out” normal business borrowing. In this case, economic growth will not be affected, but inflation will be accelerated instead. Higher expected inflation will lower the real rate of return, and the currency in this case will decline. Note also that high economic growth may signal an economy that is overheating, and the expectations of the resulting higher inflation can
lead to currency weakness instead of strength.

Exchange Rate Intervention

One other major governmental influence on the exchange rate arises through its perceived willingness to intervene directly in the FX market to influence the currency’s value. Direct intervention can involve buying the currency (and selling a reserve currency) in order to lower the supply of that currency in the FX market, and thereby strengthening the currency value. Conversely, a country can choose to sell its currency (and buy a reserve currency) to weaken its value. The willingness of a government to intervene in the market varies considerably between countries, and also can vary across time for the same country as internal conditions change. Some countries maintain a pegged currency with substantial reserves available to defend the pegged
level if necessary. In this case, the currency’s value will change only if the government exhausts its resources, or decides that the cost of defense—in reserves and the economic effect of high interest rates—is too great. Hong Kong and a few other countries go one step further and maintain a currency board—reserves greater
than 100 percent of the outstanding currency—to support its pegged value, demonstrating to the market that the government has invested the resources necessary to defend the currency value at all costs. Some countries will allow the currency to change in value within certain bands, or to vary in value against a basket of
currencies, depressing the currency’s volatility without maintaining an exact pegged value. China for example recently revaluated the yuan and now fixes the yuan against an unannounced basket of currencies.

Some countries will manage the currency value infrequently, seeking to move the currency only when it departs too far from what is judged to be its true or equilibrium value. The market pays close attention to indications of government opinion concerning currency value, and to changes in monetary reserves as an indication of
government ability to intervene.

Whether a particular intervention changes the currency value often depends on the size of the intervention (or a country’s potential intervention as measured by reserves and potential borrowing) in relation to the currency’s daily turnover in the FX market. A government’s intervention may, however, act as a signal and change the market’s perception of the equilibrium value of the currency. In this case, a small intervention can result in a significant currency movement. Many governments also try to surprise the market in the hopes that speculators will be caught off guard and forced to unwind their positions, adding to the effect of the intervention.

Balance of Payments

Ultimately, a currency is demanded by (or supplied to) the FX market in order to purchase foreign goods or foreign financial assets. The supply and demand for the currency, and its price, will strongly depend on the trade flows and funds flows between countries. Another set of economic fundamentals relates to the flow of a
country’s goods, services, and financial assets in the international market, the balance of payments.

The balance of payments tracks all of a country’s international transactions during a defined time period. In broad terms, the balance of payments has three components: the current account, capital (or financial) account, and the change in monetary reserves. The current account includes transactions in physical goods (exports
less imports, or the balance of trade), in services, in investment income (interest and dividend payments on outstanding financial liabilities), and in unilateral transfers (such as foreign aid, wage remittances from guest workers overseas, etc.). The capital account includes direct investment (Foreign Direct Investment, or FDI) and
portfolio flows (the purchase or sale of financial assets and bank borrowing and lending). The change in monetary reserves tracks the increase or decrease in the government’s holdings of financial assets denominated in a reserve currency. As discussed, many countries maintain a large reserve account to guarantee the ability to defend a weakening currency should the need arise, and the changes in monetary
reserves will reflect these interventions in the FX market. For countries that do not use direct intervention to influence currency value, like the United States, the change in monetary reserves is a relatively small number in the balance of payments accounts.

Balance of Trade

The degree to which a currency is influenced by factors related to the balance of payments depends on the degree of openness of the economy, usually measured as the relative percentage of GDP involving traded goods and services. The currency of a more open economy, like Singapore, will be more affected by balance of payments flows (or expected changes in flows) than that of the more relatively closed US or Europe.

If a country’s exports or imports are concentrated in one or a few articles of trade, its currency value can be particularly affected by the supply and demand for that commodity. “Commodity countries” such as Canada and Australia are large suppliers of natural resources. The movement in export prices of coal or wool (Australia), or
metals and forest products (Canada), relative to imports can move these countries’ currency values. The strong commodity prices of 2004 to 2005 resulted in an exceptionally strong Canadian and Australian dollar versus the US dollar. On the other hand, a country like Japan that must import a sizeable proportion of its raw material
needs can see its currency weaken in response to rising commodity prices.

A country’s terms of trade—the relative prices of a country’s exports compared to its primary imports—also affects its currency value. A country whose primary exports are expected to decline in value relative to its primary imports can expect continuing currency depreciation.

Current Account

Under accounting rules, the balance of payments balances: the current account plus the capital account and the change in monetary reserves in any period will be close to zero (net of errors and omissions). Currency value can change when there is a potential imbalance in one of the balance of payments components that requires a sizeable offset in its other components. If a country is running a current account deficit, all else equal, its currency will tend to weaken unless it can attract sufficient financial flows to pay for the deficit on physical goods or services. This is why the US dollar’s value in recent years has been influenced strongly by expectations on whether it can attract sufficient foreign investors to fund the large and growing current account
deficit. Similarly, a country like Japan that runs a strong current account surplus will use the foreign exchange it earns to acquire foreign financial assets. Japan runs a large current account surplus and as a result holds a substantial capital account deficit consisting in part of US financial assets, particularly US Treasury Bonds.

A current account imbalance can be caused by a number of factors. Some determinants are related to a country’s long-run ability to trade with the outside world. For instance, a decrease in a country’s competitiveness, particularly its productivity, can lead to real currency depreciation. On the other hand, a large increase in business investment, relative to the level of domestic savings, such as occurred in the US in the late 1990s, can lead to a real currency appreciation. Note that both of these examples result in a decline in the current account but have opposite effects on currency value. This points out the necessity to determine the real reason behind current account imbalances in order to determine the expected change in the currency’s value. Note also that there are other ways besides currency depreciation to address a current account deficit: if a country makes an effort to decrease government spending and/or raise tax revenue, the currency may suffer a smaller decline (or none at all) as foreign investors believe that the structural imbalance is being addressed
without the necessity for a currency depreciation.

Capital Account

The other component of the balance of payments, the capital account, can also have a significant effect on exchange rates as foreign investors buy currency to acquire factories and other facilities, to purchase bonds or equities for portfolio investment, or to participate in a privatization, merger, or acquisition.

Market Factors

While there is no long term correlation between equity market performance and currency value, a stock market’s performance, or expected performance, can support currency values as happened in the US equity market in the late 1990s despite a large current account deficit. Similarly, the yen declined along with the Japanese stock
market of the 1990s despite Japan’s strong current account surplus.

The role of interest rates and inflation differentials in financial flows has been discussed previously. One other indication of possible currency movement is the relative proportion of short-term (generally maturity less than one year) foreign liabilities in the balance of payments accounts. Generally, a high proportion of short-term investments results in a higher currency volatility, as investors can very quickly abandon a currency if economic variables, or perceptions, change. FDI, on the other hand, is a relatively stable financial flow which is difficult to reverse, and strong FDI flows generally indicate currency stability.

Political Risk

The level of political risk—the possibility that political events in a country will impact the economic well-being of investors—can also affect currency value. Political risk can take one of three forms. Transfer risk refers to the ability of investors to repatriate funds from a foreign country, and includes various restrictions on foreign currency holdings, the licensing or rationing of foreign currency, taxes on remittances, or outright denial of transferability. Operational risk relates to interference in the way a company can transact business. There is a wide variety of possible political interference in business operations, ranging from employment restrictions through sales price controls to export requirements. Ownership risk denotes interference in the enjoyment of ownership rights, including requirements on the percentage of foreign ownership, forced disinvestment, or outright expropriation.

The level of political risk can be assessed using a broad array of measures, depending on the type of political risk most relevant to the particular foreign investor. FDI investors will be more concerned with ownership risk, while bond investors will look more closely at sovereign spreads (the difference between US government and
foreign government rates of interest). Ultimately, if the market perceives an increase in political risk levels, a country’s currency will depreciate as fewer investors purchase assets, or sell assets in response to this risk. Traders in FX must pay much attention to the political events and crises that happen in a country, and adjust their reactions accordingly.