Currency fluctuations are a natural response to the floating exchange rate system, that most of the important economies follow as a norm. To begin with, the exchange rate directly impacts the state’s economy. It is a tedious job to witness the national economy’s highest functioning if there isn't any competent management. It is the market condition that influences the exchange rate.
Let's understand in detail how currency changes can have an impact on the economy.
What Factors Contribute Towards Fluctuating Currency?
Some of the factors which contribute to changes in currency are:
• Relative supply of the currencies
• Demand for the currencies
• A country’s economic growth
• Governmental policies
• Inflation outlook
• Capital flows
• Unemployment rate
All of these factors are ever-changing and result in continuous currency fluctuations. The country’s currency fluctuation can affect the country’s growth. Based on whether the currency of a country depreciates or appreciates, it can have both positive and negative consequences on the country’s economy.
The Far-Reaching Impacts of the Fluctuating Currencies
Most people either overlook or don't give much attention to the exchange rates, because they are not required to. It is a domestic currency that dominates the life of a typical man. And exchange rates come under the limelight only for occasional transactions like:
• Overseas remittances
• Import payments
• Foreign travel
While an international traveller might entertain strong domestic currency, given how it would make his Europe trip budget-friendly. But the disadvantage of a strong currency is that it can exercise a massive drag on the country’s economy for a long time, given how all the major industries are made non-competitive and loss of jobs. While some might vouch for strong currency, weak currencies can lead to better economic advantages.
Currency Changes and in What Ways Does It Impact the Economy?
The currency’s level has a direct impact on the economy, here’s how:
It Has an Impact on the Merchandise Trade
This denotes the exports and imports of a country. Generally speaking, a weaker currency can turn imports costly, while making exports inexpensive for overseas customers who wish to buy them, by restoring the exports. In contrast, a stronger currency can minimize the competitiveness of export and make imports inexpensive, which can result in trade deficits and further widening. It, therefore, makes the currency weak in a self-adjusting system.
However, before this takes place, the industries dependent on export can be completely ruined by an unduly strong currency.
It Has anEffect on the Country’s Economic Growth
As per the economy’s GDP’s basic equation, it can be concluded that the more the net exports’ value, the higher is the GDP of the nation. Net exports are inversely correlated with the domestic currency’s strength.
It Influences the Capital Flows
Countries with strong governments, non-fluctuation currencies and great economies receive a flow of foreign capital. For a country to influence foreign investors to invest in capital for its benefit, it has to have a non-fluctuation currency. Otherwise, overseas investors might get discouraged by the currency depreciation and the exchange rate it inflicts.
Capital flows are of two types:
Foreign Direct Investment (FDI): here foreign investors either take stakes in the present companies or create new units in the recipient market.
Foreign Portfolio Investment: here the trade securities are traded, sold and bought in the recipient market by the foreign investors. The Foreign Portfolio Investors comprises of:
• Qualified Portfolio Investors or QFI
• Foreign Institutional Investors OR FII
• NRI
The FPI investments have remained volatile for severalyears, given the business’ cyclic nature and the forex trading cost which can be significantly lowered.
The FDI is a fundamental funding source for evolving economies of India and China. The FDI is always chosen and picked over FPI, given how FPI is hot money and can differ based on a nation’s government policies and events.
What Do Governments Prefer Between Foreign Portfolio Investments and FDI?
The governments prioritize and opt for FDI over foreign portfolio investments, given how the latter can quickly leave the country if conditions become tense. Negative events like currency devaluation can trigger capital flight.
Inflation
Imported inflation can be a result of devalued currency for substantial exporter countries. A sudden reduction of about 20% in the domestic currency can lead to imports being charged 25% more. This is because a decline of 20% refers to a requirement of a 25% increase to return to the main price point. Inflation is one of the disadvantages of expansionary monetary policy. Inflation results in the reduction of money's real value because of money overflow which triggers a reduction in the interest rates. The lower the interest rates, the lower the domestic currency’s demand which causes currency depreciation.
Interest Rates
As you might have read earlier, the central banks consider exchange rates when creating the monetary policy. A strong domestic currency exercises economic drag while obtaining similar results to that of a tighter monetary policy. Additionally, making the monetary policy tighter, even when the domestic currency is strong might aggravate the problem by influencing foreign investors to invest in hot money and asking them for higher-yielding investments.
How Does Currency Changes Affect the Businesses of the Country?
Have you ever wondered how currency fluctuation can affect the businesses of the country? The fluctuations in currency can have an impact on all types of businesses, irrespective of their trade. However, the most affected businesses from currency fluctuations are the ones that either export supplies or import supplies like livestock and raw materials from other countries. A business’s foundation can be shaken by fluctuating currencies, especially there is involvement from the foreign market.
The Fluctuating Currencies Can Affect Businesses That Doesn’t Trade with Other Countries
It doesn’t matter if a business doesn’t deal or engage in trading with foreign countries, the currency fluctuation can still affect them. For example, if a company uses transport to move its products from the warehouse to the distribution centre, the changing currency can fluctuate the fuel cost, hereby affecting the transportation cost. And despite how trivial it looks from far, the overhead cost can become huge if logistical problems of mass volumes are involved, especially for the small and medium entrepreneurs.
Can Fluctuating Currencies Influence Investment Strategy?
Currency fluctuations are in the headlines most of the time, but that isn't a sufficient reason for the investors to have a panic response. It is not easy to forecast the fluctuations of individual currencies, so before overreacting to the FX market volatility, investors should take note. Rather than considering exchange rate fluctuations as an indicator of improving the returns, they must rather work on minimizing the portfolio currency risks.
But investors who have a long-term vision might have to go beyond the horizon of a specific currency pair to have a look at the foreign exchange market in its entirety, for the sake of achieving diversity.
The currency fluctuations have a direct impact on the economy but are intangible. The currency changes can result in a major impact both on the global and domestic levels. Smart individuals should research different ways of making optimum use of it. The entrepreneurs who are looking forward to product export should protect the risks associated with changing currencies by different protective solutions available in the market.
