Determinants of Foreign Exchange Rates

Determinants of Foreign Exchange

Pranav Gupta Page 1


Rates

By Pranav Gupta

Introduction

Exchange rates are relative prices of national currencies, and under a floating rate

regime they may be viewed as being determined by the interplay of supply and demand

in foreign exchange markets. The exchange rate simply expresses a national currency's

quotation in respect to foreign ones. For example, if one US dollar is worth 45 Indian

Rupee, then the exchange rate of dollar is 45 rupee. Therefore, the exchange rate is a

conversion factor, a multiplier or a ratio, depending on the direction of conversion. Thus,

the exchange rate can also be considered a price of one currency in terms of the other.

A higher currency makes a country's exports more expensive and imports cheaper in

foreign markets; a lower currency makes a country's exports cheaper and its imports

more expensive in foreign markets. A higher exchange rate can be expected to lower

the country's balance of trade, while a lower exchange rate would increase it.

Exchange Rate is one of the most important determinants of a country's relative level of

economic health. Exchange rates play a vital role in a country's level of trade, which is

critical to most every free market economy in the world. For this reason, exchange rates

are among the most watched analyzed and governmentally manipulated economic

measures. But exchange rates matter on a smaller scale as well as they impact the real

return of an investor's portfolio.


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Here we look at some of the major forces behind exchange rate movements.

General Political Stability: The extreme diversity within India’s socio-economic environment is highlighted in the varied political cultures and ideologies across the country. The legislative environment from state-to-state differs considerably as states enjoy significant autonomy. India’s much talked about corruption woes were put on the world stage due to high profile investigations and arrests related to irregularities concerning the 2010 Commonwealth Games and auctioning of 2G wireless spectrum. These scandals have tarnished the government’s image and emboldened the BJP-led opposition groups to challenge the government. For example, calls for a joint parliamentary investigation into these allegations paralyzed the winter 2010 parliamentary session. Controlling rising costs of essential food items has also been a challenge. The UPA came to power on a pro-poor platform and therefore has to balance liberalization efforts with the immediate needs of segments of the population most vulnerable to price shocks. Anti-government protests over rising costs of living have been common-place. Several state assemblies will hold elections throughout 2011/12; the UPA is therefore likely to refrain from unpopular reform including subsidy cuts.


International Parity

Conditions

Balance of Payments

Economic Policies of a government (Fiscal Policy,

Budget, Investment policy and

Foreign Trade

Policies) and a country’s

central Bank (Cost of money, interest rates,

monetary policy)

General macro

economic conditions

of the country

Inflation levels and

trends

Balance of Trade

Market Psychology

& perception

General political stability


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Investment Environment: Despite India’s foreign investment policy allowing 100% FDI in most sectors, India has thus far failed to reach its full potential as a destination for FDI. Government attempts at increasing FDI inflows have been hampered by several impediments including pervasive corruption, an unwieldy bureaucracy, and a critical infrastructure deficit. Corruption in India is widespread especially in the public sector. The deep-rooted patronage systems, bureaucracy, and weak governance contribute towards these high levels of corruption. India’s Supreme Court of late has been taking an active stance in fighting corruption. The judiciary especially at the higher levels is considered competent and fair, recent judicial sector reforms are said to have reduced the huge backlog of cases and increased efficiency. Regulatory uncertainty, both at the federal level and between federal and state levels continues to pose challenges. South Korea’s POSCO’s five year struggle to start a steel mining project in Orissa was emblematic of this lack of regulatory clarity between the Federal government and states. The eventual approval of the project in February 2011, albeit with strict environmental conditions may prove a way forward for large high profile projects. General macro economic conditions of the country Real GDP growth slowed to 8.2% y/y in Q4-10, bringing overall growth in 2010 to 8.6%. On a seasonally adjusted basis however, real GDP fell 2.1% an annualized rate from 15.5% in Q3. Despite a greater contribution from net trade, a decline in government spending and a sharp slowdown in investment took the momentum out of the Indian economy. Across sectors, the slowdown was widespread, with only agriculture and finance showing a pick-up in growth. Industrial activity stood at a near standstill in Q4, rising 0.2% q/q, as


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spending on capital goods and intermediate goods fell. Consumption spending rose slightly but remains well below potential, expanding 0.4% q/q. Fiscal policy: Plagued by various scandals, the government presented a budget for FY2011/2012 that is weak on reforms and consolidation. At the same time, the government has maintained or increased a number of populist measures, such as price subsidies on sensitive items as well as the rural workers guaranteed employment program. The forecasted improvements over the next 2 years rely on optimistic growth assumptions and improvements in tax collection, as well as the capacity to contain spending within the allocated budget. On the positive side, the budget reinforces the government’s commitment to infrastructure and education development and highlights some progress in key changes in the tax systems (direct and consumer taxes), both of which are impediments to unlocking India’s growth potential. As a share of GDP, the central government deficit is expected to reach 4.6% of GDP in FY2011/2012 (excluding off-budget food, fuel and fertilizer price subsidies and the deficits of state governments), from 5.1% in FY2010/2011. Monetary policy: After a lull in Q4, inflationary pressures picked up again early in 2011, pushing the Reserve Bank of India (RBI, the central bank) to return to a tightening stance, raising interest rates by 25 basis points for the repo and reverse repo early in 2011. The move was prompted not only by resilient inflation pressures, with inflation remaining stubbornly high at 8.2% for both the CPI and WPI in January, but also strong demand for credit, which accelerated to 22.5% y/y in December from 18.2% in November. While the increase in prices is partly driven by food shortages, the ramping up of M2 growth and non-food inflation since are also of concerns. As such, additional tightening is expected early in the year. External sector: Despite strong export growth and remittances inflows, the current account balance continued to expand as a share of GDP in Q3, rising to 4.3%. In Q4 however, the trade surplus shrank to US$21.3 billion in Q4, after averaging over US$30 billion in the first 3 quarters of the year, driven by resurging exports, up 28.4% y/y, and a sharp slowdown in imports, up 1.8% y/y, a sign of the slowing economy. With rising oil prices and the capital account vulnerable to outflows, the balance of payment and rupee are expected to weaken in 2011. However, the level of foreign exchange reserves remains stable at US$274 billion, up from US$254 billion in May 2010, and sufficient to cover 7 months of current account debit.


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Inflation trends The aggregate inflation rose to 8.4 percent in December 2010. This sudden increase in the whole sale prices is primarily because of rise in the prices of primary food articles (especially vegetables) and fuel products. While the WPI of food articles rose by 13.5 percent in December 2010 from 10.1 percent in previous month i.e. November. Inflation in fuel group surged from 10.3 percent in November 2010 to 11.2 percent in December 2010. Monthly trends in Wholesale price index- monthly average (% change)


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Foreign Exchange Reserves India forex registered an increase by USD 4.9 billion during the month of December 2010. India’s foreign exchange reserves were valued at USD 297.3 billion, an increase by 2.3 percent in December 2010 as against the 1.9 percent decline in November. The upsurge in foreign currency assets from USD 263.2 billion in November 2010 to USD 267.8 billion in December 2010 attributed to the increase in forex kitty during the month. Monthly trends in foreign exchange reserves ($ billion)

Stock market trends The key benchmark indices of Indian stock market showed modest rise in both the markets during the last month of the calendar year 2010. The index BSE Sensex and the S&P CNX Nifty on 3rd January 2010 closed at 20, 561 k and 6157 k respectively.

Government budget deficits or surpluses

The market usually show negative reaction to the widening government budget deficits, and react positively to narrowing budget deficits. The reflection of this impact is shown in the value of a country’s currency.

Balance of trade levels and trends

The demand for goods and services is illustrated by the trade flow between countries,

which in turn indicates the demand for a country’s currency to conduct trade. The

competitiveness of a nation’s economy is reflected by the surpluses and deficits in trade

of goods and services.


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Market Psychology

The foreign exchange market is influenced by Market psychology and trader perceptions in a variety of ways:

Flights to Quality

Unsettling international events can become a reason which leads to a "flight to quality,"

with investors looking for a "safe haven." Then there will be a greater demand, thus a

higher price, for currencies that are believed to be as stronger over their relatively

weaker counterparts. The Swiss franc has acted as a traditional safe haven during

times of political or economic uncertainty.

Long-term Trends

Currency markets usually move in visible long-term trends. Although there is no annual

growing season for currencies like physical commodities, business cycles do make

themselves felt. Cycle analysis looks at longer-term price trends that may have risen by

the economic or political trends.

"Buy the rumor, sell the fact"

We can apply this market truism to many currency situations. It is the tendency for the

price of a currency to show the impact of a particular action before that it has taken

place and, when the expected event comes to pass, the reaction is in exactly the

opposite direction. This condition might also be known as a market being "oversold" or

"overbought".

Economic numbers

Economic policy can certainly be reflected by the economic numbers, some reports and

numbers take on a talisman-like effect: the number it becomes significant to market

psychology and it might show an immediate impact on short-term market moves. In the

most recent years, for example, money supply, employment, trade balance figures and

inflation numbers have all impacted severely on market moves.

Technical trading considerations

As in other markets, the accumulated price movements in a currency pair such as

apparent patterns can be formed by EUR/USD, that traders may opt to use. Price charts

are studied by many traders in order to identify such patterns.


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Conclusion 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:

1. http://en.wikipedia.org/wiki/Economic_history_of_India

2. BIS (Bank of International Settlements). 2007. Foreign Exchange and Derivatives Market Activity in 2007, Triennial Central Bank Survey, December. 3. India’s exchange rate conundrum June 25th, 2010 Author: Renu Kohli 4. www.rbi.org.in 5. http://www.forecasts.org/exchange-rate/india-rupee-exchange-rate.htm

http://www.investopedia.com/terms/c/capitalgain.asp

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Determinants of Foreign Exchange Rates