The inevitable consequence of floating exchange rates, often used for most major countries, are currency swings. Many variables affect exchange rates, including economic performance, inflation prospects, differentials in interest rates, capital flows, and so on.
Many individuals are not careful about currency rates since they seldom need to. The normal everyday life of a person is carried out in their native currency. Exchange rates concentrate primarily on infrequent transactions, such as international trips, import payments, or foreign transactions.
An international traveler might be home to a strong local currency since travel to Europe would be cheap. The drawback, however, is that a strong currency may have a substantial impact on the economy over the long run, as whole sectors become competitive and thousands of jobs are lost. Although some may favor a strong currency, a weak currency may provide greater economic advantages.
In the foreign exchange market, the value of the local currency is an important factor for central banks when setting monetary policy. Directly or indirectly, the exchange rates may have a role in your mortgage interest rate, the income on your investment portfolio, the food prices on your local store, and even the possibilities for work.
Currency Fluctuations Impact on Economy
Foreign money tends to migrate to strong nations, a dynamic economy, and stable currencies. To attract money from international investors, a country requires a reasonably stable currency. Otherwise, the threat of losses in exchange rates caused by monetary depreciation may discourage foreign investment. When the investors are discouraged the value of exchange rates, usually, depreciates.
Those who are involved in Forex trading use several tools, like impulse and correction in forex trading, in order to forecast future currency fluctuations in the marketplace. Governor Mark Carney of the Bank of Canada stated it takes into consideration the continuing strength of the Canadian currency in formulating monetary policy in September 2012. Carney said the strength of the Canadian currency was one reason why the monetary policy of his nation was “exceptionally adaptive” for so long. And in addition to that, according to the people who use advanced forex trading strategies in the market, exchange rates are a significant factor in the establishment of monetary policy for most central banks.
There are two kinds of capital flows:
FDI, where foreign investors take hold of existing businesses or construct new facilities on the recipient’s market, and
Foreign portfolio investments, where foreign investors purchase, sell, and trade securities on the recipient’s markets. For developing economies like China and India, FDI is a vital source of financing.
Governments typically favor FDI investment in overseas portfolios because the latter is hot money that may leave the nation fast under difficult circumstances. This flight of capital may be triggered by any unfavorable event, such as currency depreciation.
A devalued currency may lead to ‘imported’ inflation for significant importing nations. A sudden 20% drop in the local currency may lead to imports costing up to 25% more since the 20% loss implies that the initial price point needs a 25% rise.
The economy draws on a strong internal currency which has the same effect as a tighter monetary policy (i.e. higher interest rates). Moreover, additional tightening of monetary policy in times of strong currency may aggravate the issue by drawing hot money from overseas investors seeking greater returns on investment (which would further strengthen the domestic currency).
The FX market is the world’s most frequently traded market with more than $5 trillion moved daily and well above global stocks.
The Asian financial crisis, which started in the summer of 1997 with the Thai baht devaluation, is a classic illustration of the devastation produced by unfavorable currency movements. The devaluation happened following an intensive speculative assault on the Baht, compelling the central bank of Thailand to renounce its US dollar bond and float the currency. This contagion of currencies extended to neighboring nations including Indonesia, Malaysia, and South Korea, resulting in a catastrophic decline in these economies with bankruptcies rising and stock markets plunging.
US-based investors who think the greenback weakens should invest in strong overseas markets since foreign exchange gains increase your profits. Take the S&P/TSX Composite Index from 2000 to 2010. During this time, the S&P 500 Index was practically flat, while the TSX produced about 72% Canadian dollar gains. The US dollar returns were approximately 137 percent, or 9 percent, of US investors purchasing Canadian equity with greenbacks, as a result of the strong appreciation of the Canadian currency.
The United States has several big multinational businesses that draw a considerable portion of overseas sales and profits.
This is certainly not an urgent problem since 2000, since the U.S. interest rates have been recording low for years.
At some time, though, they will rise again. If this occurs, investors who are attracted to borrow from lower interest rates in foreign currencies should recall those who had to fight to return borrowed yen in 2008. The lesson of the story: don’t borrow in a foreign currency if it’s valuable and you don’t understand or can’t cover the currency risk.