What factors influence currency valuation in the global market?

3 minutes
Business tips
What factors influence currency valuation in the global market?

The fluctuation of currencies from day to day can be so nuanced and unpredictable that it is hard to discern a pattern without a thorough understanding of the driving factors. For businesses who are dealing with multiple currencies this understanding is crucial. Tracking and predicting currency valuations means that international transactions can be timed to reduce losses and boost profits, whether that’s paying overseas suppliers or staff or receiving a lump sum.

This article will provide a guide to the factors influencing currency valuations, and point out methods of reducing unnecessary costs associated with foreign transactions. This will help keep profit margins as healthy as possible.

How did currency valuation evolve?

The earliest forms of money were made of materials that were inherently valuable. This evolved into pieces of paper that could be exchanged for gold held in reserves. Later in the 20th century, this ‘representative money’ was also abandoned in favour of ‘fiat money,’ which has a changing value determined by supply and demand. Countries can print more money, but this will add to the supply and theoretically, in the absence of other factors, drive down the currency’s value.

Key factors influencing currency valuation

Interest rates

Interest rates can be seen as the cost of borrowing money, given as a percentage of the amount loaned. Set by central banks, interest rates play a pivotal role in shaping currency strength, although it’s not a simple relationship. High interest rates tend to attract foreign investment, which is likely to increase the demand for a country’s currency and thus the currency’s value. Low interest rates can spur consumer spending and economic growth domestically, which can also have a positive influence on the currency value.

Inflation rates

Inflation is the general increase or decrease in purchasing power within a country. It tends to have the opposite effect on currency valuation as interest rates, with higher rates driving the currency down. As higher interest rates can lead to higher inflation rates, these two forces can balance each other out to some degree. That’s because inflation measures how much more expensive goods and services have become, and pricier goods can be less attractive to investors. Low inflation can mean more money flowing into the country, improving its exchange rate.

Political stability and economic performance

The desirability of holding a currency is heavily influenced by the stability of a nation’s government and economy. Investors need to feel that holding cash assets in the currency is safe. A volatile political and economic climate will deter investors, driving the currency’s value down.

Balance of trade and national debt

How much demand is there internationally for a country’s goods and services, how much is it reliant on buying from abroad and how much does the country owe? All these things will have an impact on the value of the country’s currency. The more a country is exporting, and the less it is paying to other countries in interest and in goods received, the higher its currency should be.

Fiscal and monetary policy

Countries can alter the amount of money in circulation and adjust interest rates in order to influence macroeconomic outcomes. The management of these variables is known as monetary policy, while fiscal policy determines how much the central government earns through taxation and how it spends money. This can have an impact on a country’s national debt or surplus. Both monetary and fiscal policy can influence a currency’s value.

What are exchange rate regimes?

An exchange rate regime is a method of managing a currency on the foreign exchange market. This management of exchange rates is carried out by central banks, to protect their country’s economy, and sometimes to strengthen ties between countries. There are two main types of exchange rate regime:

Floating (or flexible) exchange rate regimes: When exchange rates are determined solely by market forces, and by activities such as buying and selling currency reserves, changing interest rates, and foreign trade agreements. Today, most of the world’s currencies are floating, such as the United States dollar, the euro, the Indian rupee, the pound sterling, the Japanese yen, and the Australian dollar.

Fixed (or pegged) exchange rate regimes: When a country determines the value of its currency in relation to the value of another currency or commodity. For example, many currencies were once pegged to gold. If the value of gold rose, the value of the currency fixed to gold would also rise. Today, many currencies have fixed their value to the U.S. dollar, or euro or British pound. The Saudi riyal is fixed at $0.27 USD, due to the economic relationship between the two countries.

There are some countries that maintain a fixed exchange rate, but for a basket of currencies rather than a single currency. There are also countries, including China and Singapore, that “loosely fix” their currencies (i.e. fix the value to a trading range) to a basket of currencies.

The role of global market sentiment

Understanding global market trends and sentiment is crucial for navigating currency markets effectively. The more data is incorporated into forecasting models, the more accurate currency valuation predictions can be. The type of events that can be relevant include:

Political elections: These can be a time when a country’s approach to monetary and fiscal policy changes. Parties that are seen as promoting economic growth and fiscal responsibility may reassure investors that the country’s economy will remain stable, helping boost the currency valuation.

Conflict and natural disasters: War, earthquakes, floods, tornadoes and other disasters can devastate a country’s infrastructure and population, requiring large amounts of spending and negatively impacting its currency valuation. Historically, post-war rebuilding efforts have often been financed with cheap capital resulting from lower interest rates, which inevitably decreases the value of domestic currency.

Trade deals: It’s been shown that currency volatility often drops after a trade deal, which can have a positive effect on currency valuation.

Essentially, any event that shapes investor perceptions of the safety or riskiness of investing in a currency will have an impact on the currency’s value. There are many types of economic data that indicate stability and certainty that will bolster confidence in a currency, leading to appreciation.

How tech is shaping currency markets

Since the invention of Bitcoin in 2009, there have been waves of predictions about the disruptive effect that digital currencies and cryptocurrencies could have on the traditional currency market. These currencies challenge legacy notions of money and payment systems. They create value that can be traded on the market, without being tied to a central bank and thus being influenced by the type of political and economic factors mentioned above. They also allow people to buy and sell anonymously, although regulations have been introduced to restrict this.

The demand for Bitcoin and other cryptocurrencies like Ethereum is still high, with market caps for both in the hundreds of billions. They bring opportunities for new types of investors and businesses to participate in global markets. A drawback of cryptocurrencies is that they can be notoriously volatile, although “stablecoins” have been introduced more recently, which are pegged to the price of assets, to offset this effect. 

Despite this sustained interest in crypto, analysts have asserted that the technological advancements behind these currencies may ultimately have more impact than the currencies themselves. Central banks themselves can make use of blockchain technology and the mechanism of digital currencies to enhance efficiency, security and transparency. “Central bank digital currencies,” also referred to as e-money, represent an emerging area of interest and could help facilitate cross-border payments and help with financial inclusion in developing countries.

Although it has been a decade and a half since the advent of crypto, the repercussions in terms of technological advancements and their impact on the currency market are still unfolding.

Manage currency risk with Airwallex

With the complex interplay of factors affecting currency valuation, it’s important for businesses to control the controllables when it comes to their own financial management. Artificial Intelligence (AI) and Machine Learning (ML) technology can help create advanced prediction models for currency valuation in real time. Holding multiple currencies and accessing lower-than-average FX rates can also make a big difference to your bottom line. 

Airwallex offers multi-currency Global Accounts, which provide fast, cheap, secure cross-border transfers, multi-currency cards and market-beating FX. Funds can be collected, held and sent in major currencies including USD, EUR, CNY and SGD.

If you are processing a large amount of foreign transactions, FX risk can be intelligently managed with Airwallex, which offers around-the-clock access to pricing and conversion services, including on weekends and public holidays. Rates can be locked in for set periods of time for 1000+ currency pairs, and settlement can be either immediate or arranged for a specified date.

Learn more about Airwallex’s fast, cost-effective international transfers here and how you can eliminate FX risk from your cross-border operations programmatically here

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