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© 2018 by The Discerning Investor.

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What drives currencies

Understanding the factors behind currency moves

Currency movements play an integral part in our lives. Whether we embark on that vacation, send our children abroad for education, or hold foreign currencies in business accounts. Understanding what affects currencies empowers us to make better decisions.

What is a currency really?

Since the end of the Bretton Woods System in 1972, which effectively tied the value of international currencies to the value of gold and which required central banks hold gold as collateral, currencies have become “fiat money” – without intrinsic value. Confidence in currency values today, is thus predicated on governments’ ability to maintain their political and economic systems, defend their country militarily, and prevent inflationary shocks. The U.S. dollar is the world’s premier reserve currency because of its large successful economy, deep liquid treasury markets, and unparalleled military.

So long as we believe today’s economic systems will persist, and trust governments’ ability to defend their borders and monetary systems, we will perceive currencies to retain purchasing power over goods and services. If our perceptions change, currencies may lose their values altogether. Such was the case for Argentina in the 70s, where recession, a military coup and continued monetary expansion left the peso less than a 100-billionth of its original pre-crisis value.

Currencies are a relative value

Currencies are quoted as a ratio of another currency. For example, USD/SGD refers to the amount of SGD exchangeable for every 1 USD. Hence, factors driving prices of currency pairs, are relative to demand/supply dynamics of one currency against another. You can and will see, a single currency fare well against a basket of currencies, and poorly against a separate basket.

Interest rates

Interest rates play a significant role in currency prices internationally. Rising interest rates, all else constant, increases the demand for that currency relative to its peers. This process typically continues until we reach covered interest rate parity, where arbitrageurs can no longer make risk-free profits by borrowing in one currency (lower interest rate), lending in another (higher interest rate), and fixing the exchange rate at maturity through a forward contract. This act is also known as the “carry trade”.

Covered interest rate parity

In theory, should forward contracts diverge from the covered interest rate parity model, there exists arbitrage opportunity, and will be quickly corrected by market participants. Note that deviations can occur for a myriad of reasons. Including – credit risk of counter-parties, transaction costs and market liquidity.


Inflation decreases the purchasing power of a currency, and hence its relative value against other currencies, all else held constant. Typically, currencies experiencing higher rates of inflation depreciate relative to those experiencing lower rates of inflation. Inflation’s impact on forex markets is further determined by central bank policies, in particular – its interest rate policies. Often, rising but predictable inflation is offset by higher interest rates (which is positive for the currency and lowers longer-term inflationary expectations). Recently, the U.S. Federal Reserve has continued its monetary tightening policy, predicting 3 gradual rate hikes in 2018 to prevent overheating and unexpected spikes in inflation. This has lent support to the U.S. dollar and resulted in a flatter yield curve (a sign that long-term inflationary expectations remain modest). Central banks’ inflation projections and interest rate policies are thus closely watched by market participants.

Persistent high inflation when an economy is in recession is however, a different predicament. Stagflation limits central bank flexibility, as it is forced to choose between worsening unemployment or rising inflation. Political pressure to alleviate a populations’ suffering, runs the risk that lawmakers will tolerate higher inflation in efforts to reduce unemployment, and can lead to a sharp depreciation of a currency.

Economic competitiveness

A nation’s exports and imports of goods and services plays a significant role in exchange rate determination. Exports require foreign corporations and individuals to sell their currencies for the exporter’s currency, boosting the exporter’s currency relative to their own. Conversely, imports require domestic corporations and individuals to sell their currencies for foreign currencies, weakening the domestic currency. The balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends, is reflected in the current account. A current account deficit shows a country is spending more on foreign trade than it is earning, leading to an excess demand for foreign currencies. A current account surplus shows a country is earning more on foreign trade than it is spending, leading to an excess demand for the domestic currency by foreigners.

The long-term trajectory of a nation’s current account balances will be determined by its competitiveness compared to other nations. A more competitive nation enjoys higher productivity, lower costs of production and/or higher quality products compared to its less competitive peers. Nations may enjoy a comparative advantage in specific types of goods and services. For example, Japan and Europe possess a comparative advantage in automobiles due to their skilled talent pool and advanced technologies, while China enjoys a comparative advantage in manufacturing due to their low cost and abundant labor. To enhance their competitiveness, nations may invest in human capital through education, scientific research on modern technologies and manufacturing processes, or create regulation and tax laws that enhance investments in certain industries. Today’s policies thus, have profound impact on a nation’s future competitiveness and currency value. To the extent that they increase competitiveness and the current account surplus, the currency can be expected to appreciate.

Trade barriers including tariffs and sanctions have an opposite effect, as they disrupt the natural flow of goods and services. Often, industries crucial to a nation’s defense, such as steel-making and energy, are protected by trade tariffs to ensure their availability during times of war.

Economic growth and financial system stability

Strong overall economic growth with ample investment opportunities and strong consumer-led spending, attracts foreign capital and hence causes a currency to appreciate. Conversely, weak and declining economic growth with limited opportunities, weak consumer spending and heightened risks, leads to foreign capital outflows and currency depreciation.

High private debt (households and corporations), especially in foreign denominated debt, poses great risks to an economy. As leverage increases, severe asset price corrections can have very damaging impact and threaten the solvency of financial institutions and corporations, the backbone of capitalist economies, and whose survival is essential to facilitate economic activity. Too much foreign denominated debt, exposes economies to speculative activity and “guilty by association” perceptions. Before the 1997-8 Asian financial crisis, Indonesia was a prosperous economy, with a trade surplus of more than US$900 million, foreign reserves of more than US$20 billion and a strong banking sector. However, its corporations had borrowed heavily in U.S. dollars, to take advantage of lower borrowing costs. When neighboring Thailand could no longer defend its baht and floated it, speculators were quick to sell the rupiah amid fears over its corporate debt burden. In 1998, the rupiah plunged from roughly 2,600 rupiah to 1 U.S. dollar, to 8,000 rupiah to 1 U.S. dollar.

Political stability and public debt

Political instability caused by the rise of strong opposition groups that threaten to derail the incumbent governments’ plans, revolutionary activities, or increasingly despotic regimes, may cripple an economy and its currency. In 2017, Venezuela saw rising unrest as its ruling party dissolved the National Assembly and stripped it off its legislative powers and parliamentary immunity. 920 battalions were created and maintained, composed of 200,000 militias to respond to violent protests. As a result, from January 2017 to January 2018, the Venezuelan bolivar lost 98% of its value and the economy went into depression.

High public debt encourages inflationary policies to reduce the debt burden in real terms, such as expanding the monetary supply. And if a government is not able to service its interest payments, it must issue debt to domestic and eventually foreign lenders, raising its borrowing costs and default risks, further weakening its currency. The effect of debt on currency is ultimately determined once again by the trust and confidence investors place in the issuing government. For stable governments with long track records of timely debt repayment and strong currencies, this may not be a big issue. The U.S., Japan, France, U.K. and Germany all have above average levels of debt as a % of GDP but enjoy low borrowing costs and high investor demand, due to faith in their governments and economies.

Figure 1: Public debt to GDP and 10-year government bond yields


Market attitudes towards risk

In times of prosperity and market risk-on, investors increase their portfolio weights of riskier assets, such as emerging market equities and bonds, raising demand for soft currencies as they hunt for higher yields. In 2018, a stronger global economy and capital flowing from U.S. investments to other developed markets and emerging markets, are expected to see the U.S. Dollar depreciate against a basket of currencies.

In times of market duress such as the 2008-9 crisis, hard currencies such as the U.S. Dollar, Japanese Yen, Swiss Franc, Euro, and Pound Sterling are often quick to appreciate, as investors pull capital out of riskier markets and asset classes, and into the safety of developed market government bonds.

Figure 2: US Dollar index