Before we look at these forces, we must always sketch out however exchange rate movements have an effect on a nation's trading relationships with different nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign exchange markets; A lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. a higher exchange rate is often expected to lower the country's balance of trade whereas a lower exchange rate would increase it.
1) Interest Rate differentials among nations:
This is the one most important factor affecting a currency. The rate of interest differential between nations is a 1st-factor affecting exchange rates. Suppose the interest rates on Government deposits within the US area unit 2% and in India is 8%. Wherever can you like to invest? Clearly in India.
So as money moves from the US to India there's additional demand for Rupees that strengthens the Indian currency. Currently, the exchange value of $1 can reduce like Rs.60, Rs.63 until some change in status quo.
As flow will increase into a nation, its currency gains value and gets stronger. Because the central bank of every country decides their interest rates, the difference in interest causes inflow or outflow.
Inflation is that the 2nd known factor. For instance, India has decided to spur business growth by easing interest rates. And say, India has 3.5% inflation at the time. Not terribly many money managers would rush to pull their money out of India.
This is as a result of even if it's going to earn less interest; their money would lose less buying power with 1% inflation level increase. If they find another country wherever there's a better difference among low inflation rate and higher interest rates, they're going to eventually move.
But it would not be as hasty because it would be to induce out of a currency suffering double-digit inflation. This is often what happened to India last year. With inflation on the high, money was flowing out of India.
Remember once everyone was talking $ exchange can reach Rs.65. it’ll reach Rs. 70 in few days like. This is often as a result of Rupee as currency was weakening against the greenback.
The often overlooked factor. However shrewd money managers don’t neglect this. The productivity of a nation’s workforce may also decide however big money companies manage their money.
Productivity is an important factor for the nation. It’s one amongst the foundations on that the country’s price structure is based. A workforce with higher productivity (more goods each hour or day) will afford to get higher wages and still price their product competitively.
Japan, Germany is among the foremost productive nations. A rate of interest drop of 1% within the U.S. can create panic. However, the same drop is less impactful on a currency like Mark or Yen.
Why? In such a productive nation inflation is unlikely to rise to a point wherever real rate of return gets unattractive
4) Real Rate of Interest/Return:
It is the actual rise or fall in purchasing/spending power every year. The crude formula is.
Real Rate of Interest = Government Rate – Inflation Rate
Suppose in The India nation the interest on AAA-rated government security is 8%. The rate of inflation is 7%. Then the real rate of interest in India is simply 1%.
To consider another example, if you earn 11% interest in the European country (Germany) once the rate of inflation is 4%, then actual real gain left is 7%. Some 1% drop in real rate may cause cautious fund managers to move their money to a different country wherever it earns higher.
Once money starts flowing out from a country, the currency value weakens as a lot of it's sold. It’s probably to get devalued until the selling continues.
5) Balance of Trade:
It is how much the country takes within the form of selling goods as exports to how much it buys as imports. Here defined roughly for your easy understanding.
Balance of Trade = Cost of Exports – Cost of Imports
Example, if a country exports less than it imports, and then it's the negative balance of trade. The higher negative, the bigger disadvantage to a nation. This means too much of its currency is flowing out. India imports a lot of fossil fuel (Crude oil) and Gold that has an effect on its balance of trade.
Note: a better approach would be considering the balance of payments that is actual cash flow instead of accounting entry term like Balance of Trade. The balance of payment a lot of accurately affects the exchange rate of currency.
To borrow George Soros’ words “A nation with large investment capital from abroad may show a big surplus in International payments even if it has a deficit in straight exchange of Goods. This is useless to evaluate a decision. So I always look at Balance of Payments”.
A nation that has the positive balance of payments can have the higher exchange rate with the stronger currency. Another important factor affecting currency within the Forex market.
6) Political Climate:
The next important or probably 3rd most important factor in the list. The political climate of a country has a very significant impact on the rate of exchange of its currency. A stable government might additional or less be taken without any consideration in most major nations and thus not have an effect on currency a lot of.
But instability, just like the uprising in Sudan, an overthrow of Saddam Hussein, military absorbing power, breaks up of euro of these have effects on respective currency.
Will you invest with somebody who could be a drunkard or liar? The same applies to investments in an exceedingly country. Even recently, tensions between U.S. and Russia on Ukraine issue caused stock market selling and, therefore, US $ downfall due to speculation in markets.
People who management large sums of money would like stability for peace of mind. They don't need to bet just on a hope that policies are consistent and agreeable. There are more than two hundred countries to invest in and succeed. Simply the knowledge that modification could come back is enough to make a currency slide.
7) Labor situation:
Labor situation could be a somewhat ‘also’ factor. I hesitated to include this, however, did it anyway? If there's nearly full unemployment then there's likely to be no purchasing power and hence no sense to take a position. This causes currency devaluation.
Similarly, if there are labor strikes often, then this affects productivity. Additional a strong union workforce means that frequent wage will increase affecting the profitability of companies.
A nation with high unemployment has a low rate of inflation is that the popular perception. Strike threats and labor unrest depress currency as investors and markets dislike uncertainty, lower productivity, and better wages. They will all be a potential blocker to foreign inflow.
8) Commodity prices:
commodity prices have an effect on currencies differently depending on the use of these commodities in every country. Plenty of that depends on whether or not a country is an importer or exporter of a specific commodity.
Crude oil costs typically are a good example of this. Canada is mostly thought of because the currency to benefit most from rising oil prices as a result of it exports so much oil. Or else, the United States usually is hindered by rising oil prices as a result of studies have shown that as gas prices rise, consumers cut spending on different discretionary items to make up the difference.
"[The Aussie and Canadian dollars] react most quickly to commodity price changes. The impact that commodity prices have on other currencies is probably additional from a demand side," Boyd says. "If demand is up, the Aussie and Canadian get that boost right away, but then it’s a matter of wherever that demand is coming from."
All these factors in totality have an effect on the currency price. It’s also a total of however money managers react and the way they price each factor. Knowing however a currency performs is an important factor to think about during investments.
But if you’re considering the next five years then it's going to not be a lot of impactful. However, in short-term it's a definite game changer. A pointy devaluation of currency brings the market down in a jiffy.