A country’s exchange rate is generally set by its central bank as authorized by the reigning government. Nevertheless, these rates are not static as they are subject to upheavals in the global forex market which is even prone to crashing. Below are factors that affect the forex rate between trading countries:
Countries with thriving economies will experience little to no inflation within a financial year. Such countries tend to have the upper hand when trading with partners whose currency is continually inflating, creating an unstable economy. Lebanon is an ideal example to illustrate this point. Data from Bloomberg indicates the country has the most considerable annual inflation rate globally, as of September this year.
As the financial meltdown in the Middle East unfolds, Lebanon has surpassed Zimbabwe, which is known for grossly high inflation. The Lebanon Central Administration of Statistics derives that consumer prices increased by 10.25 per cent, and food prices spiked by 20.82 per cent within a month. As a result, the country’s currency has lost 90 per cent of its value, leaving 75 per cent of the population destitute.
In this scenario, it doesn’t matter what the government had set as the exchange rate of its currency against major currencies; the Lebanese Pound will not trade favorably.
Current Account Deficits
Current account means the balance of trade between a nation and its trading partners. It must factor in all payments for goods and services traded and the interest rates and dividends. If a country is spending more of its currency in foreign trade than it is getting back, a deficit occurs. In simpler terms, there is less demand for its products and services among its trade partners, who may have robust in-house manufacturing capacity.
The extra demand for a foreign currency decreases the value of its exchange rate so much that its domestic goods and services are cheap for its trade partners. Likewise, buying assets from these trade partners becomes too expensive, so foreign holdings are declined in the local market. After accruing a deficit, the said country may borrow an injection of capital from other sources to cover the balance.
Terms of Trade
Terms of trade (TOT) refers to the comparative price of exports compared to what a country is importing from its trade partners. If the price of exports is higher than what a government spends importing goods and services, then the terms of trade are favorable.
Increasing demand for exports leads to rising revenues, and this trend boosts the need for a nation’s currency. Furthermore, a good TOT raises the nation’s currency value. However, if the price of exports increases relative to what the country is selling, the value of currency decreases.
Countries usually engage in extensive deficit financial planning when laying down critical infrastructure to spur economic growth and fulfill specific mandates. For instance, expanding the road network to remote parts of the country promotes trade from big cities to rural areas. Building community colleges in underserved areas to increase access to higher education is another example.
Countries that need to keep borrowing to sustainable development projects are not appealing to foreign investors because they fear inflation and how it would impact their business.
A country’s currency in the international forex market is heavily determined by its economic performance. The fastest-growing economies attract foreign investors who wish to expand their multinational firms to stable markets worldwide. According to IMF’s projections in April this year, Libya tops the list of growing economies, and India is not too far behind, ranking at number five.
While the Covid 19 pandemic has weakened economies, in Sub-Saharan Africa, there is promising growth spearheaded by South Africa and Angola. The two-strongest economies have extraordinary attributes that attract foreign capital, such as economic stability and geographic locations, giving them access to the Indian Ocean coastline.
In the end, many factors affect a country’s forex exchange rate, and these factors keep changing due to foreseeable or unpredictable reasons. The unfolding Covid 19 pandemic is a prime example of unforeseeable events that have adversely impacted economies. The international forex market will continue to witness changes as other events unfold, such as political strife in the Middle East.