4 Key Macroeconomic Factors that Affect FX Rates

Understanding foreign exchange (FX) rates

By definition, forex (FX) rates represent the value of one currency against another and they fluctuate based on supply and demand.

Foreign exchange rates are the price at which one currency can be exchanged for another currency. These rates are typically expressed as a ratio of one currency to another. For example, if the Euro-to-US dollar exchange rate is 1.2, it means that one Euro can be exchanged for 1.2 US dollars.

When it comes to international trade, businesses must convert between two (or more) currencies during the import or export of goods and services process. The exchange rate can impact the cost of these transactions and, consequently, the profitability of the business.

How foreign exchange rates impact the global economy

One crucial element in the cycle of FX rates is that it is a feedback loop — FX rates impact the global economy, while the global economy impacts the FX rates.

Breaking this down, FX rates influence trade, which is a significant driver of economic growth through economic activities such as tourism, foreign investment, and global capital flows.

To illustrate, a weaker currency can make a country's exports more affordable, which can increase demand for those products. This increased demand, in return, leads to increased production and job creation, which can boost economic growth. Now, if we flip this over, a stronger currency can make imports cheaper, which can lead to increased consumer spending and inflation.

From another perspective, FX rates also impact global capital flows. Investors may choose to invest in countries with higher interest rates, which can lead to increased demand for that country's currency. This increased demand then drives up the value of the currency and making it more expensive for other countries to import goods and services from that country.

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Factors that impact foreign exchange rates

There can be a plethora of factors that can either sway the value of a currency upwards or downwards. However, it boils down to four major macroeconomic indicators.

Factor 1: Inflation rates

Inflation rates are one of the most significant drivers of foreign exchange rates. Inflation refers to the rate at which the average prices of goods and services increase in an economy. In other words, the purchasing power of a country's local currency. A high inflation rate makes a currency less valuable, while low inflation rates make it more valuable.

Inflation is seen to negatively affect exchange rates. Therefore, the goal of central banks around the world is to manage and reduce inflation rates to a suitable level.

Diving a level deeper, it is important to note that inflation rates can be influenced by a variety of factors, such as changes in the money supply, government policies, and external shocks like natural disasters or geopolitical events. For example, a sudden increase in oil prices can lead to higher inflation rates, as the cost of transportation and production increases, leading to higher prices for goods and services.

In reality, if a country's inflation rate is higher than that of its trading partners, its currency will depreciate, making its exports more competitive. But, if a country's inflation rate is lower, its currency will appreciate, making imports cheaper.

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Factor 2: Interest rates

Interest rates — the cost of borrowing money — are yet another critical driver of foreign exchange rates.

Monetary policy is adopted by the central bank to control inflation, which impacts the currency exchange rate. Often, central banks try to cool inflation by increasing interest rates. This higher interest rate then makes it more attractive to foreign investors and would likely increase the demand for the country’s currency which then increases the value of the currency.

For instance, let's say that the interest rate in the United States is higher than the interest rate in Japan. This means that investors can earn a higher return by holding onto US dollars than by holding onto the Japanese yen. As a result, investors may sell their yen and buy dollars, which can lead to an increase in the value of the dollar relative to the yen.

Not just that, when central banks prefer to keep a dovish stance in monetary policy. This means they favour low-interest rates to promote domestic spending which might lead the currency to drop.

Factor 3: Political stability and economic performance

Political stability and economic performance influence a country's ability to attract foreign investment and can impact trade relations.

Political events, such as uncertainty around political outcomes can lead investors to seek safe-haven currencies (USD, EUR, JPY, CHF), which can appreciate in value. A stable political environment can provide investors with greater confidence, leading to increased capital flows.

On top of this, investors look to economic indicators, such as GDP, employment rates, and inflation levels to determine the potential economic growth for a country. Countries with strong economic performance may attract more foreign investment, leading to increased demand for their currency and a stronger exchange rate.

An example of this is the GBPUSD index during the 2008 recession:

Source: MacroTrends

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Factor 4: Government debt

Government debt refers to the amount of money that a government has borrowed to finance its operations.

High levels of government debt can make investors nervous, as it can lead to concerns about a country's ability to repay its debts. This can cause investors to demand higher returns, leading to a weaker exchange rate. Conversely, countries with lower levels of debt may be viewed as more stable, leading to higher demand for their currency.

An important item to note is the sovereign credit rating, which assesses a country's ability to repay its debts. Countries with higher credit ratings may be viewed as more stable and attractive to investors, leading to a stronger exchange rate. Countries with lower credit ratings may face higher borrowing costs, leading to a weaker exchange rate.

Takeaway

As a multi-national business, a strong exchange rate for the currencies you transact in could lower your business cost, and consequently, increase net income.

However, businesses today are not completely at the mercy of volatile FX rates. There are ways to hedge currency risks such as using a multi-currency wallet or virtual accounts that allow you to transact in a foreign currency as if you’re a local.

Check out Wallex if you’re looking for a simplified payment solution that will help you streamline your global payments while reducing FX risks.