Exchange rates are one of the most watched and analyzed economic measures across the world and are a key indicator of a country’s economic health. The exchange rate can be defined as the rate at which one country’s currency may be converted into another. Rates are not just important to governments and large financial institutions. They also matter on a smaller scale businesses
There are several forces behind exchange rate movements and it is useful to have a basic understanding of how these affect one country’s trading relationship with other countries. Strong currencies make a nation’s exports more expensive and imports from foreign markets cheaper, whereas weaker currencies make exports cheaper and imports more expensive. Higher exchange rates adversely affect a country’s balance of trade but lower exchange rates have a positive effect on it. This article looks at 3 factors that determine foreign exchange rates in Nigeria.
Changes in inflation causes changes in currency exchange rates. Generally speaking, a country with a lower rate of inflation will see an appreciation in the value of its currency.
The price of goods and services increases at a slower rate when inflation is low. Countries with a continually low inflation rate exhibit an increasing currency value, whereas a country with higher inflation typically experiences depreciation of its currency and this is usually accompanied by higher interest rates.
Interest rates, inflation and exchange rates are all correlated. Central banks can influence both inflation and exchange rates by manipulating interest rates. Higher interest rates offer lenders a higher return compared to other countries. Any increase in a country’s interest rate causes its currency to increase in value as higher interest rates mean higher rates to lenders, thus attracting more foreign capital, which in turn, creates an increase in exchange rates.
In the event a country’s economy falls into a recession, its interest rates will be dropped, hindering its chances of acquiring foreign capital. The consequence of this is that its currency weakens in comparison to that of other countries, thereby lowering the exchange rate
Current Account/Balance of Payments
A country’s current account reflects its balance of trade and earnings on foreign investment. It comprises of the total number of transactions including exports, imports and debt. A deficit in its current account comes as a result of spending more of its currency on importing products than through exports. This has the effect of lowering the country’s exchange rate to the point where domestic goods and services become cheaper than imports, thereby generating domestic sales and exports as the goods become cheaper on international markets.
All of the factors described above determine foreign exchange rate fluctuations and the exchange rate of the currency in which an investor’s portfolio holds the majority of its investments determines its real return. A declining exchange rate thus decreases the purchasing power of income and capital gains derived from any returns. Overall, exchange rates are determined by many complex factors and although these cannot always be easily explained, it is important for investors to have some understanding of how currency values and exchange rates play a key role both in the economy and in the rate of return on their investments.