Home ›› 20 Jan 2023 ›› Editorial
Currencies are exchanged in the foreign exchange market, but what determines the rates at which they are exchanged for one another?
This is really a question of prices. What determines the price of one currency in terms of another currency?
There are mainly two formats. They are fixed and free or floating exchange rates.
Bangladesh operates on a free or floating exchange rate. As such our major area of concentration will be on free/floating rate in response to the free operation of the forces of demand and supply.
The foreign exchange value of a national currency will be closely related to that country’s balance between exports and imports.
It will also be influenced by the capital transactions between the country and the rest of the world. In addition to normal commercial transactions, there are the activities of the speculators to consider.
Speculators buy and sell foreign currencies with a view to making a capital gain. The attraction of free and floating exchange rates is that it provides a kind of automatic mechanism for keeping the Balance of Payments in equilibrium
Industrialised countries account for a large proportion of international trade and capital flows. For this reason much of the world trade is denominated in the currencies of these countries such as dollar, yen euro and pound. Since these countries operate floating exchange rates it is estimated that between two-thirds and four-fifths of the world trade is conducted in floating exchange rates. However, this does not mean that exchange rates have been allowed to absolutely freely float. Although the market forces are the main determinant of the rates of exchange, there are times, when the Central banks try to influence the market rates. They can do this by adjusting interest rates by intervening directly in the foreign exchange market, thereby reducing or increasing foreign exchange reserve. If the central bank does not intervene, it is called ‘clean float’. If the central bank does intervene, it is called ‘dirty float’. Governments attempt to manage the exchange rates in order to smooth out fluctuation around what is believed to be the equilibrium rate of exchange. Further, a major cause of instability in the foreign exchange market is the growing importance of capital movements.
Foreign currency fluctuation is a common phenomenon under free/ floating exchange rate. A number of factors impact exchange rate which is a natural event for major economies. Economic theory of Demand and Supply plays a major role in the fluctuation of major trading currencies. Economic performance, trend of Inflation, Interest rates differential, Short term capital flows, the Strength and Weakness of the economy etc. are the underlying factors behind the frequent fluctuation in the currency rates. Currency exchange rates impact merchandise trade, economic growth, capital flows, inflation and interest rates. Currency movement affects financial markets. Investor may benefit/ lose in currency fluctuations. Hedging (buying in future) is an option to avoid currency fluctuation. General public who are not in global merchandise trade remain un- concerned about currency fluctuation as they mostly deal in domestic currency, However, they become interested in the currency fluctuation only when they make foreign travel, import payments or overseas remittance.
Strong domestic currency makes foreign travel less costly by making foreign currency cheaper. But the downside is a strong currency could exert significant drag on the economy over the longer term, as entire industrial sector would be rendered non-competitive and thousands of jobs would be lost. Some policymakers might prefer strong currency. On the other hand a weak currency could result in more economic benefits. The value of the domestic currency in the foreign exchange market is a key element for the central bank while formulating monetary policy. Currency rates play a part in the interest rates when mortgage payment is concerned, return on investment and the prices of essentials at local markets.
Merchandise trade refers to a country’s imports and exports. A weaker domestic currency against foreign currency makes imports more expensive and stimulates exports cheaper for overseas customers. The weak / strong foreign currency impacts an economy’s Balance of trade showing it in the deficit or surplus. A weak domestic currency compared to foreign currency allows export business to remain competitive in international markets. On the other hand a strong domestic currency can reduce export competitiveness and makes imports cheaper, which can cause a trade deficit to widen further eventually weakening the currency in a self - adjusting mechanism. But before this happens, export dependent industries can be damaged by an unduly strong currency.
Now let us put our attention to the economic front of an economy. To have a clear picture let us look to the basic formula of calculating the Gross Domestic Product (GDP). Normally GDP is calculated as: GDP=C+G+I+ NX, where C stands for consumption expenditure, G stands for Government expenditure, I stands for Investment expenditure and NX stands for (Exports-Imports).
As such when the net value of exports is greater than imports, the higher shall be the GDP. However, we know that exports have an inverse relationship with strong domestic currency. Foreign capital flows into countries where there are stronger dynamic economies and stable currencies. Foreign investors prefer stable currency for investment, where foreign portfolio investment in securities is welcomed.
We know foreign direct investment (FDI) is a source of fund for growing economies like Bangladesh. Capital flight generally takes place in case of devaluation of the domestic currency. A devalued currency results in imported inflation to countries that are substantially importers. For example, a sudden 20 decline in the domestic currency could result in imports costing 25 per cent increase is needed to get back to the original price point. Exchange rates are very confidential for most central banks while formulating monetary policy. A strong domestic currency exerts drag on the economy, achieving the same result as a tight monetary policy. Tightening of monetary policy when domestic currency is strong enough may exacerbate the problem by attracting hot money from foreign investors seeking higher yield.
Exchange rate movement affects the real economy through its effect on exports and imports. A rise or appreciation in the exchange rates will tend to make exports more expensive to foreigners, but imports cheaper to domestic customers. A fall or depreciation in the exchange rate will have reverse effect making exports cheaper and imports costlier. However, much depends on the price elasticity of demand. If the price elasticity of demand for export is elastic, with a value of say, 2, then a 10 per cent rise in the price of exports to foreigners will result in a 20 per cent fall in export volumes. In such case, depreciation may lead to an increase in exports. On the other hand depreciation of the exchange rate will make export cheaper and import costlier.
Probably the foreign exchange market is the most actively traded market in the world with over $5 trillion traded daily. However, such move of enormous trading volume is left from public eye unless there is a crisis. Adverse currency moves can significantly impact finances, if there is sufficient foreign exchange exposure. There is also the question of hedge currency risk. Currency moves can have a wide ranging impact on a domestic economy and globally as well. When the green back is wealth, investors can take advantage by investing overseas. But currency fluctuation can be a potent risk when a country has a larger foreign exchange exposure, it may be best to hedge the risk.
The writer is former Director General of EPB. He can be contacted at [email protected]
