Factors Influencing Exchange Rates:
Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services and is usually expressed
in percentages.
If, for example, inflation was lower in the UK, the purchasing power of the Pound Sterling would
increase relative to other currencies. UK exports become more competitive and the demand to
purchase Pound Sterling for UK goods will increase.
In December 2022, the inflation rate in the European Union was 10.4 percent, with prices rising
fastest in Hungary, which had an inflation rate of 25 percent.
As a result, the Hungarian forint is amongst the worst performing currencies in Central Europe since
January 2022.
Research by BNP Paribas indicates that the forint has respectively lost 11 and 23 % of its value
against the Euro and the dollar. It must be stated however that inflation is just one of the contributory
factors here.
Interest rates
There is also a strong correlation between inflation, interest rates and exchange rates.
Governments and Central Banks have the authority to influence exchange rates by increasing interest rates.
An example of this is “Hot money”: the higher the interest rate the more attractive the currency offer is to
foreign investors.
This involves investors rapidly and frequently moving money from a currency with lower interest rates to a
country with higher interest rates, giving a quick return on investment.
Government/Public debt
A country’s debt rating is also a factor that influences its currency exchange rate.Public sector projects
sometimes require large-scale deficit financing which boosts the domestic economy.However, foreign investors
are less likely to invest in countries with large public deficits and government debt.Fear of a debt default can
result in the selling of bonds denominated in that currency by investors, resulting in a fall in the value of the
exchange rate. Governments may also need to print money to pay parts of a large debt, resulting in inflation.
Political stability
The strength of a currency can also be influenced by the political stability of a particular country.
Foreign investors are more attracted to invest in countries displaying a lower propensity for political turmoil.
This injection of foreign investment leads to an appreciation of the domestic currency.
Conversely, unpredictable events leading to unstable conditions in a country mean less foreign investment
naturally leading to a depreciation in the domestic currency.
In October 2022, Britain was plunged into economic and political uncertainty following the resignation of the
then Prime Minister Liz Truss after only 49 days in office. Her vast planned tax cuts crashed the pound and
sent borrowing costs soaring.
The ‘mini budget’ announced by former Chancellor Kwasi Kwarteng would have required an unprecedented
extra £411 billion in public borrowing over the following five years, pushing Britain into a crisis not seen since
the 2008 financial crash.
Economic recession
In theory, when a country enters a recession there is normally a depreciation of its currency. Why so?
Firstly, it is commonplace for interest rates to fall in a recession and when this happens, we see a flow of
money out of the country to countries with higher interest rates.
If for example, Canada entered a recession and money started to flow out of the country, its people would sell
Canadian dollars to buy other currencies resulting in a fall in the value of CAD (Canadian dollar).
It must be noted that economic and political events in other countries will also influence how a domestic
currency moves in times of recession.
For example, in a global recession, the United States may still be seen as a haven for investors (even though it
may experience high inflation and low interest rates) keeping its currency stable or even stronger than other
currencies.
Terms of Trade
The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the difference between the
monetary value of a nation’s exports and imports over a certain time period.
The terms of trade will improve if the price of a given country’s exports rises by a greater rate than that of its
imports.
A greater demand for a country’s exports means an improvement in terms of trade resulting in rising revenues
and, consequently, an increased demand for that country’s currency. This will naturally increase the value of
that currency.
Current account deficits
The current account deficit is closely related to the terms or balance of trade.
The current account measures imports and exports of goods and services but also payments to foreign holders
of a country’s investments, payments received from investments abroad, and transfers such as foreign aid and
remittances.
If for example, Britain, as a regular trading partner with Canada had a higher current account deficit this could
weaken the pound relative to the Canadian dollar.
Countries therefore with lower current account deficits will tend to have stronger currencies than those with
higher deficits.
Confidence and speculation
Political events or changes in commodity prices may cause a currency to fall in value. If speculators believe the
Euro will fall, they will sell now for a currency they feel will rise in value. For this reason, sentiments in the
financial markets can heavily influence foreign exchange rates.
If the markets are alerted to the possibility of an interest rate increase in the Eurozone for example, we are
more likely to see a rise in the valuation of the Euro as a result.
If a US speculator expects the euro to appreciate over the next 5 months, he will contract to buy euros in 5
months at a fixed exchange rate. This is known as a forward contract and this mitigates any risk and losses
caused by exchange rate volatility.
Government intervention
Governments and Central Banks have the monetary authority to intervene to stabilize a currency by
formulating trade policies, printing more money, or increasing and decreasing interest rates.
China, for example, is reluctant to allow its currency to appreciate because it will negatively impact its exports.
The Chinese government aims to boost its exports and attract foreign investment by keeping the yuan
artificially low. As an export dependent economy, China does so to compete with neighbouring countries like
Japan and South Korea.
Given China’s large trade surplus, its central bank, the People's Bank of China (PBOC) absorbs large inflows
of foreign capital. It purchases foreign currency from exporters and then issues that currency in local yuan
currency.
Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the
balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms
of trade have favorably improved. Increasing terms of trade shows' greater demand for the country's exports.
This, in turn, results in rising revenues from exports, which provides increased demand for the country's
currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its
imports, the currency's value will decrease in relation to its trading partners.
2.Currency Arbitrage
Locational Arbitrage
Locational arbitrage is the most common type of forex arbitrage and involves two currencies. We have already
given an example of this type of arbitrage above. Let us take another example, but this time with a Bid/Ask
spread.
Suppose Bank A has USD 1.52/1.57 for GBP, while Bank B quotes USD 1.58/1.60. In this case, the trader
would buy one GBP from Bank A at $1.57 and sell it to Bank B at $1.58. This way, the trader makes a profit of
$0.01 per GBP.
Let us take the same example, but with a different bid/ ask spread. Bank A quotes USD 1.52/1.57 for GBP, but
Bank B quotes USD 1.56/1.60. In this case, the arbitrage opportunity does not exist. If a trader buys GBP at
Bank A for $1.57 and sells to Bank B at $1.56, the trader will incur a loss of $0.01 per GBP.
Triangular Arbitrage
As the name suggests, this arbitrage involves the use of three currencies. Such a type of arbitrage exists if the
cross-exchange rate of two currencies does not match with the currency exchange rate.In triangular arbitrage,
we calculate the cross-exchange rate of two currencies and then compare it with the actual rate in the
exchange. Thus, we can say the triangular arbitrage benefits from the irregularities in the cross rates. For
instance, we can use USD/EUR and USD/GBP to calculate the cross-exchange rate of GBP/USD.
Let us take an example to understand this arbitrage. Suppose, at a given time, the following are the exchange
rates – USD 1.4/EUR, USD 1.7/GBP, and EUR 1.5/GBP. Now, a trader needs to calculate the cross-exchange
rate for EUR/GBP, using USD/EUR and USD/GBP.In our case EUR/GBP will be 1.7/1.4 = 1.21. However, the
actual EUR/GBP quote is 1.5. So, we can say that arbitrage opportunities exist. Let’s see how.IIn this case,
we first convert USD 1.7 into 1 GBP, then we convert this GBP into 1.5 EUR. Now, we turn this 1.5 EUR back
into USD (1.5 * 1.4) to get 2.1 USD. We made a profit of $0.4 in this trade.
Covered Interest Arbitrage
Under covered interest arbitrage, a trader uses interest rate differentials to invest in a currency. And then, the
trader hedges the risk with the help of a futures or a forward contract.
Uncovered interest rate arbitrage also exists. It is the same as covering one, but it does not have a futures or
forward contract. In this type of arbitrage opportunity, the conversion happens between a local currency with a
lower interest rate to other currencies with a higher interest rate.
Spot-future Arbitrage
In such an arbitrage, a simultaneous trade in currency happens in the spot as well as in the futures market.
For example, you purchase USD in the spot market and then sell the same in the futures market to make a
profit if there is any irregularity in pricing.
Uncovered interest arbitrage is a form of arbitrage that involves switching from a domestic currency that
carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits. With
uncovered interest arbitrage, there is a foreign exchange risk implicit in this transaction since the investor or
speculator will need to convert the foreign currency deposit proceeds back into the domestic currency
sometime in the future.
The term "uncovered" in this arbitrage refers to the fact that this foreign exchange risk is not covered through
a forward or futures contract.
Impact:Uncovered interest arbitrage involves an unhedged exchange of currencies in an effort to earn higher
returns due to an interest rate differential between the two currencies. Total returns from uncovered interest
arbitrage depend considerably on currency fluctuations since adverse currency movements can wipe out all
the gains and in fact even lead to negative returns. If the interest rate differential obtained by investing in a
foreign currency is 3%, and the foreign currency appreciates against the domestic currency by 2% during the
holding period, the total return from this arbitrage activity is 5%. On the other hand, if the foreign currency
depreciates by 4% during the holding period, the total return is -1%.
3rd Assignment:
For 1,2 and 3 Questions Refer Excel sheet
3.Inference:
India (2022):
Current Account Deficit: India has a significant current account deficit of around -$79,050.9 million excluding
reserves and related items. This is primarily due to a substantial trade deficit in goods and services,
amounting to -$267,187.6 million and -$134,661.0 million respectively.
Primary Income and Secondary Income: India has a notable deficit in primary income, which includes
investment income, of -$41,709.1 million (credit: $27,178.3 million, debit: $68,887.4 million). However, it
manages a surplus in secondary income of $97,319.0 million, indicating positive inflows in this category.
Financial Account: India's financial account shows a deficit of -$50,683.9 million. It has substantial direct
investment abroad ($14,532.2 million) but also significant liabilities in direct investment ($49,940.3 million).
Overall BOP Balance: The total balance on the current, capital, and financial account stands at -$28,426.6
million, and when considering net errors and omissions along with reserve items, the BOP surplus decreases
to -$30,610.4 million.
Colombia (2022):
Current Account Deficit: Colombia also experiences a current account deficit, though relatively smaller
compared to India, standing at -$21,333.3 million excluding reserves. This deficit is driven by trade imbalance
in goods and services, amounting to -$12,177.5 million and -$16,585.0 million, respectively.
Primary Income and Secondary Income: Colombia has a primary income deficit of -$17,056.5 million
(credit: $6,974.2 million, debit: $24,030.7 million). It records a surplus in secondary income of $12,308.3
million, showing a positive balance in this category.
Financial Account: Colombia shows a financial account deficit of -$21,037.1 million. It attracts foreign direct
investment assets ($3,383.2 million) but also holds significant liabilities in direct investment ($17,182.5
million).
Overall BOP Balance: The total balance on the current, capital, and financial account stands at -$296.1
million. Including net errors and omissions and reserve items, Colombia shows a small surplus of $553.5
million.
General Comparison:
Both countries exhibit current account deficits, largely driven by trade imbalances in goods and services. India
shows a larger deficit compared to Colombia in almost all major categories, including the overall BOP
balance. India's deficit in primary income is notably larger than Colombia's. Colombia showcases smaller
deficits in its financial account compared to India.
4.How BOP impacts the Exchange rate?
The Balance of Payments (BOP) influences exchange rates through several channels, as it reflects a
country's economic transactions with the rest of the world.
Current Account and Exchange Rates:
Trade Balances: A country with a persistent trade surplus (exports > imports) typically experiences an
appreciation in its currency. Conversely, a trade deficit (imports > exports) might lead to currency depreciation.
For instance, if a country consistently imports more than it exports, it might lead to a weaker exchange rate.
Current Account Deficits/Surpluses: A sustained current account deficit (including trade, services, income,
and transfers) can put downward pressure on a currency as it suggests the country needs more foreign
currency to meet its obligations.
Capital Account and Exchange Rates:
Capital Flows: Strong inflows of foreign investment (such as Foreign Direct Investment - FDI or Foreign
Portfolio Investment - FPI) can create demand for a country's currency, leading to its appreciation. Conversely,
if there's a significant outflow of capital, it can put downward pressure on the currency.
Financial Account Dynamics: Movements in a country's financial account, such as changes in ownership of
assets like stocks, bonds, and other financial instruments, can impact the demand for its currency.
Overall BOP and Exchange Rates:
BOP Surpluses/Deficits: Persistent deficits in the overall BOP may weaken a country's currency as it
indicates a continuous need for foreign capital to fund the shortfall, potentially leading to a devaluation.
Reserve Accumulation: Countries building substantial foreign exchange reserves can signal stability and
strength in their currency, leading to potential appreciation.
Expectations and Market Sentiment: Besides the actual BOP figures, market perceptions and expectations
about a country's economic performance can heavily influence exchange rates. Positive expectations about
future economic growth, stability, and policies can lead to currency appreciation, even if the current BOP
shows a deficit.
Central Bank Intervention: Central banks might intervene in foreign exchange markets to stabilize or
influence their currency's value. They can buy or sell their currency to manage its value concerning other
currencies.
5.Various factors that cause disequilibrium:
There are a number of reasons for market disequilibrium. Sometimes, disequilibrium occurs when a supplier
sets a fixed price for a good or service for a certain time period. During this period of sticky prices, if the
quantity demanded increases in the market for the good or service, there will be a shortage of supply.
Another reason for disequilibrium is government intervention. If the government sets a floor or ceiling for a
good or service, the market may become inefficient if the quantity supplied is disproportionate to the quantity
demanded. For example, if the government sets a price ceiling on rent, landlords may be reluctant to rent out
their extra property to tenants, and there will be excess demand for housing due to the shortage of rental
property.
From the standpoint of the economy, disequilibrium can occur in the labor market. A labor market
disequilibrium can occur when the government sets a minimum wage, that is, a price floor on the wage that an
employer can pay its employees. If the stipulated price floor is higher than the labor equilibrium price, there
will be an excess supply of labor in the economy.
When a country’s current account is at a deficit or surplus, its balance of payments (BOP) is said to be in
disequilibrium. A country’s balance of payments is a record of all transactions conducted with other countries
during a given time period. Its imports and exports of goods are recorded under the Current Account section
of the BOP. A significant deficit on the current account where imports are greater than exports would result in
disequilibrium.
The US, UK, and Canada have large current account deficits. Likewise, when exports are greater than
imports, creating a current account surplus, there is a disequilibrium. China, Germany, and Japan have large
current account surpluses.
A balance of payments disequilibrium can occur when there is an imbalance between domestic savings and
domestic investments. A deficit in the current account balance will result if domestic investments are higher
than domestic savings since the excess investments will be financed with capital from foreign sources. In
addition, when the trade agreement between two countries affects the level of import or export activities, a
balance of payments disequilibrium will surface.
Furthermore, changes in an exchange rate when a country’s currency is revalued or devalued can cause
disequilibrium. Other factors that could lead to disequilibrium include inflation or deflation, changes in the
foreign exchange reserves, population growth, and political instability.
6.Views to attain BOP equilibrium in india:
Achieving Balance of Payments (BOP) equilibrium in India demands a comprehensive and multi-dimensional
strategy. To address the substantial deficits across various BOP components, India could embark on initiatives
focused on trade balance enhancement. Promoting export growth through incentivization, reduced trade
barriers, and increased competitiveness, alongside managing import expenditure through import substitution
strategies and efficiency enhancement, could narrow the trade deficit. Leveraging India's strengths in
service-oriented industries such as IT, software services, healthcare, and education can further boost service
exports. Balancing the primary income account could be achieved by attracting more foreign investment,
necessitating a conducive investment climate, streamlined regulations, and enticing investment opportunities.
Managing capital flows effectively, with a focus on encouraging long-term investments and regulating
short-term portfolio investments, can stabilize the financial account. A judicious monetary policy aligned with
domestic economic goals and external stability, fiscal prudence, and managed exchange rate policies can aid
in this equilibrium. Structural reforms aimed at infrastructure development, export diversification, and reducing
dependency on select markets or products are crucial. Strengthening institutions responsible for trade,
investment, and fiscal policies, coupled with robust data monitoring and swift responses to emerging
imbalances, would bolster efforts toward sustained BOP equilibrium. This multifaceted approach
acknowledges the necessity of a delicate balance between domestic priorities and global economic realities,
underscoring the importance of continuous adaptation to changing market dynamics.
