Having a floating exchange rate is a must for any major economy. Floating exchange rates, which also contribute to currency fluctuations, generally get influenced by a wide range of factors, such as the state of a nation’s economy, the likelihood of inflation, differences in interest rates, capital flows, and more. The strength or weakness of the underlying economy usually determines the exchange rate of a currency. As a result, the value of a currency can change at any time.
Currency impacts
Exchange rates are often ignored by the public because they are rarely necessary. An average person uses the local currency to conduct his/her daily business. Only in the case of infrequent transactions like international travel, import payments, or foreign remittances, exchange rates become a concern. A strong national currency would appeal to foreign visitors because it would make trips to the country more affordable.
However, there is a drawback, as over time, a strong currency can significantly hinder the economy by making entire industries uncompetitive and resulting in the loss of thousands of jobs. Although some people might favour a strong currency, there are more economic advantages to a weak currency.
One of the most important factors that central banks take into account, when determining monetary policy, is the value of the home currency on the foreign exchange market. Currency fluctuations can affect several things, including your mortgage interest rate, investment portfolio returns, the cost of groceries at your neighbourhood supermarket, and even your chances of landing a job.
The economy is directly affected by the level of a currency in many manners. Take merchandise trade for example. This represents the imports and exports of a country. A weaker currency generally raises the cost of imports while lowering the cost of exports for buyers abroad.
Over time, a country’s trade surplus or deficit may be attributed to its currency, which may be strong or weak. Say, for instance, that you are an American exporter who offers widgets to a customer in Europe for $10 apiece. The exchange rate is $1.25 for every €1. Thus, each widget will cost €8 to your European buyer.
Let us now assume a weakening of the Dollar and an exchange rate of €1=$1.35. You can afford to give your buyer a break and still make at least $10 per widget, but they want to bargain for a lower price. Your price in Dollars is $10.13 at the current exchange rate, even if you set the new price at €7.50 per widget, which is a 6.25% discount from your buyer’s perspective. A feeble Dollar makes it possible for your export company to compete in global markets.
On the other hand, if imports become more affordable and exports become less competitive, the trade deficit may increase and the currency may eventually weaken as a result of a self-adjusting mechanism. However, an overly strong currency can harm export-dependent industries before this occurs.
Another case study is the capital flows. Strong governments, robust economies, and stable currencies are typically associated with a flow of foreign capital into those nations. For a country to draw in money from international investors, its currency must be reasonably stable.
In the absence of such, foreign investors may be discouraged by the possibility of suffering exchange-rate losses due to currency devaluation. Foreign direct investment (FDI) refers to the process by which foreign investors build new facilities or acquire stakes in companies already operating in the recipient market.
On the other hand, foreign portfolio investment involves the buying, selling, and trading of securities in the recipient market by foreign investors. For developing nations like China and India, FDI is a vital source of funding. Foreign portfolio investments are hot money that can flee the country quickly in hard times, so governments typically prefer foreign direct investment (FDI) over them. Any unfavourable event, like currency devaluation, can cause this capital flight.
Also, significant importers may experience “imported” inflation as a result of a depreciating currency. Imports could cost 25% more in the event of an abrupt 20% decline in the value of the home currency because a 20% decline implies a 25% increase is required to return to the initial price point.
How about interest rates?
Another way the economy is directly affected by the level of a currency is interest rates. As was previously mentioned, when most central banks set monetary policy, exchange rates are a major factor. When determining monetary policy, the Bank of Canada considers the Canadian Dollar’s ongoing strength, according to Governor Mark Carney’s statement from September 2012.
Carney claimed that one factor contributing to his nation’s “exceptionally accommodative” monetary policy for so long was the strength of the Canadian Dollar. A strong home currency has a similar effect on the economy as how a tighter monetary policy does.
Furthermore, if monetary policy is tightened further during a period when the domestic currency is already strong, this could make matters worse by drawing in hot money from overseas investors looking for higher-yielding investments, which would strengthen the domestic currency even more.
Judging the global impact
With over $5 trillion traded every day, far more than all global equities, the forex market is the most actively traded in the world. Even with these massive trading volumes, currencies are typically not featured on the front pages. On the other hand, there are instances when sharp fluctuations in currency values have global effects.
One notable instance of the chaos sparked by unfavourable currency fluctuations is the ‘Asian Financial Crisis’ that commenced in the summer of 1997 due to the devaluation of the Thai baht. This devaluation followed a targeted speculative onslaught on the baht, ultimately compelling Thailand’s central bank to relinquish its fixed exchange rate with the US Dollar and allow the currency to float freely.
The adverse effects of this currency crisis then radiated to neighbouring countries including Indonesia, Malaysia, and South Korea, resulting in a substantial economic downturn characterised by a surge in bankruptcies and a sharp decline in stock markets.
The other one is China’s undervalued Yuan. China maintained the renminbi at roughly 8.2 to the Dollar between 1995 and 2005, allowing its export-led economic boom to capitalise on what its trading partners claimed was an artificially devalued and suppressed currency. China reacted in 2005 to the mounting chorus of grievances from the United States and other countries. As a result, the value of the yuan increased gradually, reaching roughly 6 RMB for every Dollar by 2013 from over 8.2 RMB in 2013.
Similarly, the Japanese Yen’s Gyrations is one such incident. From 2008 to 2013, the Japanese Yen was among the most volatile currencies. Due to Japan’s policy of nearly zero interest rates, traders preferred the Yen in carry trades, where they borrowed money for very little and used it to invest in foreign assets with higher yields.
However, as the global credit crisis deepened in 2008, terrified investors rushed to buy Yen to pay back loans denominated in the currency, which caused the Yen to appreciate sharply. The outcome was a more than 25% increase in the value of the Yen relative to the United States in the five months leading up to January 2009. Then, in 2013, Prime Minister Shinzo Abe unveiled plans for fiscal and monetary stimulus (dubbed “Abenomics”), which caused the Yen to fall by 16% in the first five months of the year.
Also, the Euro fell 20% from 1.51 to the Dollar in December 2009 to roughly 1.19 in June 2010, owing to fears that the heavily indebted countries of Greece, Portugal, Spain, and Italy would be forced out of the European Union. Over the following year, the Euro gained strength once again, but only momentarily. The Euro fell 19% between May 2011 and July 2012 as a result of renewed concerns about an EU breakup.
How can an investor benefit?
There are some ideas for profiting from currency changes. The first way is to invest overseas. Foreign exchange gains will increase your returns if you are an American investor who feels that the American Dollar is losing strength and you want to invest in robust foreign markets.
Examine the S&P/TSX Composite Index for Canada from 2000 to 2010. While the S&P 500 Index was essentially unchanged during this time, the Canadian Dollar saw returns on the TSX of roughly 72%. For American investors buying Canadian equities with greenbacks, US Dollar returns were about 137%, or 9% per annum, due to the steep appreciation of the Canadian Dollar.
The other ideas are to invest in US multinationals, refrain from borrowing in low-interest foreign currencies, and hedge currency risk. A sizable portion of the revenues and profits of the numerous large multinational corporations based in the United States come from overseas. The depreciating Dollar helps American multinational corporations’ earnings, and when the Dollar depreciates, stock prices should rise accordingly.
Since 2000, the United States has experienced record-low interest rates, so, indeed, this hasn’t been a major concern. However, the rates have risen since 2022, as the world’s largest economy, along with a huge part of the world, faced record inflation.
When such a situation, like the above one, occurs, investors should keep in mind those who had to rush to return borrowed Yen in 2008 when they were tempted to borrow in foreign currencies at lower interest rates. The lesson learnt from this tale is to never borrow money in a foreign currency if you cannot or will not be able to manage the exchange risk and it is likely to be appreciated.
Unfavourable currency fluctuations can have a big effect on your finances, particularly if you’re heavily exposed to foreign exchange. However, there are many options available to mitigate currency risk, including exchange-traded funds like the Invesco Euro CurrencyShares Japanese Yen Trust (FXY) and Euro Trust (FXE), as well as currency futures, forwards, and options. If you prefer to sleep at night, consider these.
Changes in currency can have a broad effect on both the domestic and international economies. Investors can profit from weakening US Dollars by making foreign investments or purchasing shares in US multinational corporations.
When one has a significant amount of exposure to foreign exchange, currency movements can be a powerful risk, so it might be best to use one of the many hedging tools available to reduce this risk.