How are Exchange Rates determined ? - Part 2

In the first part, some of the key factors that played an important role in determining the exchange rates between two currencies were Differentials in interest rates and Differentials in inflation rate.

Given below are some of the other factors that are equally important in determining the exchange rate between two currencies

Public debt or Government Debt: Many countries engage in large-scale deficit financing to pay for public sector projects and governmental funding. In India schemes such as NSC, NSS, Post office schemes, Indira Vikas Patra, Government bonds etc are some of the instruments that the government of India issue to borrow money from the public and at the same time makes it worthwhile for the investor to invest in these schemes. While such activity stimulates the domestic economy, nations with large debts are less attractive to foreign investors. What is the reason? A large debt causes the local interest rates to increase and when they increase, the currency appreciates with respect to the other foreign currencies.

Current-account deficits: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows that the country is spending more on foreign trade than it is earning by providing servives, goods to other countries, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

Terms of trade: This is related to the foreign trade and is a a ratio comparing export prices to import prices. 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 other currencies.

Political stability and economic performance of the country: Last but not the least, foreign investors inevitably seek for stable countries politically with strong economic performance in which they can invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. Thus when one saw a coup in Thailand some time back, that countries stock markets as well as the currencies saw major losses. As and when the political climate became better, things started to recover for them.