Because of the exchange rate system, it is normal to be currency fluctuations in the economy. Оne currency versus another currency in the exchange market creates a floating exchange rate, which in turn is influenced by many different factors, such fundamental factors and technical factors, which also includes the currencies supply and demand, their economic performance, how the market is looking on inflation of the currency, its interest rate differentials, capital flows, resistance levels, technical support, etc.
The value of currency never stays the same and fluctuates every minute of the day, keeping it in a state of perpetual flux. However, it is the economy that determines the level of which currency will be. In fact, the economy itself was originally capable of determining a currencies level, yet, it seems too often be turned around, for anytime currency begins moving in huge amounts, it is able to dictate what’s in store for the economy. In a matter of speaking, when this happens it is similar to ‘humans being an animals pet’.
Currency effects are far reached
Currency gyrations pose impacts on the economy, however, not many people actually realize this or to the extent simply because they mostly deal with their domestic currency, and for some people, it is just not one of their priorities, but for many, they just don’t give it much thought. So, a majority of the people do not pay much attention to exchange rates unless they do a lot of traveling abroad, have import payments, they have remittances that go overseas, or they engage in activities that consist of foreign currencies.
One mistake that many people have is the idea that their domestic currency is strong, for instance, it makes traveling abroad less expensive, or paying for an imported product will cost them very little. The fact is, however, that a currency that is strong and exerting can actually slow down an economy over a period of time, similar to a Corporation that can no longer be competitive, shutting down and having to lay off thousands of employees. Although consumers may dislike a domestic currency that is said to be weak due to shopping across the border or traveling abroad costing them more, the truth is that a currency that is weak actually benefits the economy.
The foreign exchange market’s value of foreign currencies is significant for the toolkit of a central bank, it helps them with sitting monetary policies, be it directly or indirectly. Therefore, affecting a variety of main economic variables. This can also have something to do with the amount people are paying for their mortgage, portfolio returns, the cost of food, and also job opportunities.
Currency impacts on the economy
The following are different aspects that can directly impact the economy due to currency levels:
Merchandise trade is a term used to describe the Nation’s International Trade system, its imports and exports. In basic terms, the weaker currency is going to stimulate the exports, making imports cost more, which is going to decrease the nation’s trade deficits, increasing surplus, over a period of time.
For instance, imagine yourself as a U.S. Exporter and two years ago had sold one million widgets at $10.00 dollars apiece to a buyer located in Europe, and the exchange rate at that time was EUR 1= $1.25 USD. This means that it costed the European buyer 8 EUR for each widget. The same buyer now wants to negotiate a better deal for another large order, however, there has been a decline in the dollar since their last transaction.
Now that the dollar has declined to $1.35USD per Euro you are in a position to not only give the buyer a break on the cost, but you will also be clearing $10.00 on each widget you sell to the buyer. So, with a price of EUR $7.50 (a 6.25% discount from your last transaction with this buyer), making your USD price $10.13 with the current exchange rate.
The depreciation of your domestic currency is the main reason that your business in exports has stayed competitive among the International markets. On the other hand, it only takes a stronger currency to lower export competitiveness, making imports cost less, but, it will, at the same time create a larger deficit and eventually, through a self-adjusting mechanism, make the currency weaker, only first, the industry sectors that are set on focusing on exports must be decimated using a stronger currency.
A basic formula of the economy’s GDP > C + I + G + (X – M). Where:
C = Consumption and/or consumer spending, which is the largest component of any economy.
I = A businesses capital investment or the capital investment of a household.
G = Government spending.
(X – M) = Net exports, or rather, exports – imports.
It clearly shows in this equation that when a net exports value is higher it is going to give a Nation a higher GDP. It was discussed previously that an inverse reaction can be reached when the domestic currency is strong enough.
Foreign capital seems to drift like the wind and right into the countries which have a stable currency, powerful economies, and strong governments. Nations have to keep a stable currency in order to get the attention of foreign investors, or else, investors from overseas could be pushed away by the prospect of having exchange losses due to currency depreciation.
Capital flows have two main types of classification – One of which, is a foreign investment (FDI), whereas, the investors from foreign Countries take out a stock in companies that already exist, or they create a new facility overseas. Another main type of capital flow is investments into foreign portfolio’s, this is foreign investors making investments in securities in other Countries. Growing economies, such as India and China, depend greatly on the FDI, as it is a critical source of their economies funding, otherwise, without any capital their growth would be constrained.
The FDI is preferred by the governments, much more so than foreign portfolio’s investments, after all, these are sometimes akin to “hot money” and have the ability to get out of the country at any time. A phenomenon that is called “capital flight,” ignited through negative events, this includes the expected and unexpected decrease in currency value.
Countries that deal in mostly imports can face import inflation whenever there is a decline in currency value. If domestic currencies value dropped by 20% it could cause imported products to cost 25% more, this is because the 20% decline is saying that it is going to take 25% more in order to make the circle back again.
As previously mentioned, most of the Central Banks use the level of the exchange rate in setting their monetary policies. For instance, it was the Governor, ‘Mark Carney’ that stated back in September of 2012, that “The bank takes into account, the Canadian dollar and its exchange rate when setting monetary policies. One of the main reasons for the Canadian dollar to be ‘exceptionally accommodating’ this long is due to its strength.”
A strong domestic currency slows the economy down having a similar ending as with a tighter monetary policy (such as i.e. having high-interest rates). On top of that, putting a tighter squeeze on the monetary policy to be in place if domestic currency becomes stronger may create more of a problem with hot money being attracted of foreign investors who want a higher yield investment, making the domestic currency go up even higher.
Examples of currencies influence, globally
Even when you include the equities, bonds, and commodities of all the trading markets the Global Forex market is still the largest financial market having more than $5 Trillion Dollars in volume trade daily. Regardless of the high volumes of trade, currencies, pretty much stay out of the news. Of course, there may be times when drastic situations occur which effects Countries all around the world. We have listed a few examples below:
1997-98, the Asian crisis
For instance, the economy can face drastic damage by the adverse moves currency itself takes, it was back in 1997, and the Asian crisis started out with the Thai baht being devalued. The occurrence if the Thai baht being devalued was after it had become intensely speculative, and attacked, which forced Thailand’s Central Bank to cut its ties with the U.S. Dollar, floating their own currencies. As a result, it triggered their financial collapse, which had spread throughout the neighboring countries of Malaysia, Hong Kong, Indonesia, and South Korea, affecting all of their economies. Furthermore, at that time Bankruptcies were occurring left and right and brought a severe contraction to their economy, while stock markets were plunging.
The undervalued Yuan of China
From 1994 – 2004 (well over a decade), the Yuan of China had been holding steady, which allowed China the ability to build-up a great deal of momentum due to the under-valued currency. Not only the U.S., but other Nations as well began to complain saying that “China was using excuses in order to keep the currency’s value down and boost their exports. In fact, the Yuan has since appeared to be gradually appreciating, going from more than 8 on a dollar back in 2005, and a little more than 6 on a dollar in 2013.
The year of the Japanese Yen’s gyrations was in the year of 2008 and up until the mid-2013. During which time the Japanese Yen is considered to fall into the group of most volatile currencies from 2008 until 2013. Global credit had started to get more intense after August of 2008, at the time Global credit was intensify, and the Yen had become the favored currency of the carry trades, while the near-zero interest rate policy of Japan was quickly appreciated by panicky investors who were buying up the currency by the dozen, in order to repay the Yen denominated loans.
This resulted in the Yen being appreciated by over 25%, compared to the U.S. Dollar between August of 2008 and January of 2009. There was a 16% plunge of the Yen between January and May of 2013, which was brought on due to the monetary stimulus plan of Prime Minister Abe, along with his fiscal stimulus plan (these are nicknamed “Abenomics.”
Fears of the Euro (2010 – 2012)
The Nations of Portugal, Italy, Greece, and Spain, had everyone concerned because they were so deep in debt, it would gradually force them out of the European Union, which causes them to disintegrate. It is what led to the Euro plunging down 20% in as little as seven months, going from a level1.51in December of 2009 down to 1.19 by June of 2010. There was a respite that led to the retracing of the currency and all the losses it had over the following year turned out it was only temporary, for the resurgence in the European Union had to break the news once more that led to fear with another plunge of 19% on the Euro happened from May of 2011– July of 2012.
What are the ways an investor can benefit?
The following suggestions can help Nations benefit from the moves a currency makes:
Invest in U.S. Multinationals
The largest number of multinational companies are located in the U.S., and many of them make a substantial amount of their revenues dealing with foreign countries, as well as their earnings. The U.S. Multinational company’s earnings get boosted from the weaker dollar, which should be translated to higher prices in stocks at a time the U.S. Dollar is at its weakest.
Hold off on borrowing any low-interest foreign currencies
A pressing issue that dates back to 2008 is seeing the U.S. Dollar’s interest rates at a record low year after year. However, there will come a time when the U.S. Dollar is going to revert back to its historically low levels. It is times like these that tempt investors into borrowing foreign currencies, having a lower interest rate. However, one needs to give considerable thought to the incidence of 2008, whereas, anyone who borrowed foreign currency that had to pay back the Yen’s borrowed. The point here being, if there is a chance that the currency borrowed is going to appreciate, it’s not fully understood, or will not hedge the exchange risk, simply do not borrow it.
Hedge currency risk
Whenever there are adverse currency moves it can most definitely make an impact on one’s finances, more so if there is a lot of forex exposure. There are many options that are available telling how to hedge a currencies risk, covering currency futures and currency forwards, to options and exchange funds that have been traded, such as, the Euro Currency Trust (FXE) and/or Currency Shares Japanese Yen Trust (FXY). A good time to hedge a currency would be if sleep was lost over it.
The moves currencies undergo can impact not only domestic economies, the impacts can hit globally, as well. This means that investors will use currency moves to their advantage, they do this by going foreign and investing overseas in U.S. Multinationals at the time the U.S. Dollar is at a weak point. Those with a rather large forex exposure take a chance on currency moves and its potential risk, and it might be wise to hedge the risk by using one of the many different hedging instruments that are now available.
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