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    of 4

    FOREIGN EXCHANGE MARKET

    SESSION 61: STABILITY OF EXCHANGE RATES

    STABILITY OF EXCHANGE RATES:

    A stable currency is one that can successfully hold its unit of account or purchasing
    power over some time. At a basic level, a currency is stable when the
    international currency exchange rates do not fluctuate too much as against the
    Consumer Price Index (CPI).

    Exchange rates express the value of one country's currency in relation to the value of
    another country's currency. The rates play an important part in economics, affecting
    the balance of trade between nations and influencing investment strategies.

    A higher-valued currency makes a country's imports less expensive and its exports
    more expensive in foreign markets. A lower-valued currency makes a country's
    imports more expensive and its exports less expensive in foreign markets. A higher
    exchange rate can be expected to worsen a country's balance of trade, while a lower
    exchange rate can be expected to improve it.

    Determinants of Stability in Exchange Rates:

    1. Differentials in Inflation:

    Typically, a country with a consistently lower inflation rate exhibits a rising currency
    value, as its purchasing power increases relative to other currencies. During the last
    half of the 20th century, the countries with low inflation included Japan, Germany,
    and Switzerland, while the U.S. and Canada achieved low inflation only later.1 Those
    countries with higher inflation typically see depreciation in their currency about the
    currencies of their trading partners. This is also usually accompanied by higher
    interest rates.

    2. Differentials in Interest Rates:

    Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
    interest rates, central banks exert influence over both inflation and exchange rates,
    and changing interest rates impact inflation and currency values. Higher interest
    rates offer lenders in an economy a higher return relative to other countries.
    Therefore, higher interest rates attract foreign capital and cause the exchange rate
    to rise. The impact of higher interest rates is mitigated, however, if inflation in the
    country is much higher than in others, or if additional factors serve to drive the
    currency down. The opposite relationship exists for decreasing interest rates – that
    is, lower interest rates tend to decrease exchange rates.

    3. Current Account Deficits:

    The current account is the balance of trade between a country and its trading
    partners, reflecting all payments between countries for goods, services, interest, and
    dividends. A deficit in the current account shows the country is spending more on
    foreign trade than it is earning, and that it is borrowing capital from foreign sources
    to make up the deficit. In other words, the country requires more foreign currency
    than it receives through sales of exports, and it supplies more of its own currency
    than foreigners demand for its products. The excess demand for foreign currency
    lowers the country's exchange rate until domestic goods and services are cheap
    enough for foreigners, and foreign assets are too expensive to generate sales for
    domestic interests.

    4. Public Debt:

    Countries will engage in large-scale deficit financing to pay for public sector projects
    and governmental funding. While such activity stimulates the domestic economy,
    nations with large public deficits and debts are less attractive to foreign investors.
    The reason being, a large debt encourages inflation, and if inflation is high, the debt
    will be serviced and ultimately paid off with cheaper real dollars in the future.

    In the worst-case scenario, a government may print money to pay part of a large
    debt, but increasing the money supply inevitably causes inflation. Moreover, if a
    government is not able to service its deficit through domestic means (selling
    domestic bonds, increasing the money supply), then it must increase the supply of
    securities for sale to foreigners, thereby lowering their prices. Finally, a large debt
    may prove worrisome to foreigners if they believe the country risks defaulting on its
    obligations. Foreigners will be less willing to own securities denominated in that
    currency if the risk of default is great. For this reason, the country's debt rating (as
    determined by Moody's or Standard & Poor's, for example) is a crucial determinant
    of its exchange rate.
    5. Terms of Trade

    A ratio comparing export prices to import prices, the terms of trade is related to
    current accounts and the balance of payments. If the price of a country's exports
    rises by a greater rate than that of its imports, its terms of trade have favourably
    improved. Increasing terms of trade shows' greater demand for the country's
    exports. This, in turn, results in rising revenues from exports, which provides
    increased demand for the country's currency (and an increase in the currency's
    value). If the price of exports rises by a smaller rate than that of its imports, the
    currency's value will decrease in relation to its trading partners.

    6. Strong Economic Performance

    Foreign investors inevitably seek out stable countries with strong economic
    performance in which to invest their capital. A country with such positive attributes
    will draw investment funds away from other countries perceived to have more
    political and economic risk. Political turmoil, for example, can cause a loss of
    confidence in a currency and a movement of capital to the currencies of more stable
    countries.

    7. The Bottom Line

    The exchange rate of the currency in which a portfolio holds the bulk of its
    investments determines that portfolio's real return. A declining exchange rate
    obviously decreases the purchasing power of income and capital gains derived from
    any returns. Moreover, the exchange rate influences other income factors such as
    interest rates, inflation and even capital gains from domestic securities. While
    exchange rates are determined by numerous complex factors that often leave even
    the most experienced economists flummoxed, investors should still have some
    understanding of how currency values and exchange rates play an important role in
    the rate of return on their investments.

    References:

    • https://www.theclassroom.com/definition-of-exchange-rate-stability
    • International Business Text Book - by P Subba Rao, Himalaya Publishing House.

    • UGC NET/JRF/SET commerce paper III by Trueman’s Series.

    • Self prepared Reference notes

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