10 Factors That Determine Currency Value

Author - Aditya Rawat, MBA, Coventry University, UK (Ex. Deloitte, MOODY's Research, and HCL-British Telecom)

Note: The views shared in this blog are based on extensive research on many authenticated websites. Others may have different perspectives.

You hear every day that USD 1 = Indian Rupee (INR) 84 or GBP 1 = INR 112 or EUR 1 = INR 93. But have you ever wondered what determines the value of one currency in another? The currency value isn't arbitrary. It is shaped by various economic factors that reflect a country’s financial health. This article explores the history behind currency systems and the factors that influence the value of currencies.

The Background of Currency Value

The concept of currency has evolved over centuries. Initially, societies relied on a barter system, which was inefficient due to the need for a double coincidence of wants. The introduction of "commodity money," made from precious metals, marked the first significant change. However, the impracticality of using physical commodities led to the adoption of "representative money," which is backed by a physical commodity, like gold.

The gold standard dominated the monetary system until the early 20th century but was abandoned during and after World War I due to the constraints it imposed on governments. The shift to fiat money—a currency that has no intrinsic value and is not backed by physical commodities—allowed for more flexibility in managing the money supply, thus facilitating economic stability and growth.

Types of Exchange Rates

The most common way to measure currency value is through exchange rates, which determine how much one currency is worth in terms of another. There are two primary exchange rate systems: Fixed and Floating.

1. Fixed Exchange Rate

In this system, a country pegs its currency to a stable anchor currency, such as the U.S. dollar. This arrangement provides stability but limits a country’s ability to respond to economic changes. Developing countries often adopt fixed rates to promote stability and attract investment.

2. Floating Exchange Rate

This system allows market forces to dictate currency value. While this can lead to higher volatility, it grants countries greater autonomy over their monetary policy. Governments may intervene to stabilize their currency but generally allow the market to set rates based on supply and demand.

Major Factors Influencing Currency Value

Exchange rates reflect a country’s economic health and play a critical role in its trade dynamics. A strong currency can make imports cheaper, but it can also make exports more expensive for foreign buyers, potentially harming a country’s trade balance. Conversely, a weaker currency can boost exports by making them cheaper for foreign consumers while raising import costs.

1. Demand & Supply

The currency value is determined by the principles of supply and demand, much like any other commodity in a market economy. For example - When demand for a currency increases relative to its supply, its value appreciates; conversely, if supply increases without a corresponding rise in demand, the currency’s value will decline. The demand for the US Dollar is high as most of the international transactions take place in these three currencies. According to the?Bank of International Settlements?-

• The US dollar is involved in almost 90% of foreign exchange transactions
• USD accounts for 85% of transactions in spot, forward and swap markets.
• More than 50% of the global trade and 75% of Asia-Pacific trade are denominated in US dollars.

2.?Inflation

Inflation refers to the general rise in prices for goods and services within an economy, often expressed as a percentage. High inflation erodes purchasing power, which can lead to a depreciation of a currency. For example-

• If the inflation rate in the UK is lower compared to other countries, the purchasing power of the Pound Sterling will increase. This will make the UK exports more competitive on the global stage and drive up the demand for the Pound as foreign buyers exchange their currency to purchase British goods.
• On the contrary, countries with higher inflation rates, such as Hungary in December 2022, which experienced an inflation rate of 25%, see their currency weaken. The Hungarian forint lost significant value against the Euro and the US dollar, demonstrating how inflation can severely impact currency performance.

3. Interest Rates

Interest rates play a vital role in determining currency value. There is a strong correlation between interest rates, inflation, and exchange rates. Central banks can influence exchange rates by altering interest rates. Higher interest rates typically attract foreign capital as investors seek better returns on their investments. This influx of “hot money”—capital that moves rapidly between markets in search of the highest yield—results in increased demand for the currency of the country with higher rates.

For example – if the US Federal Reserve raises interest rates while other countries maintain lower rates, the US dollar may appreciate as investors flock to the higher yields, further strengthening the currency.

4. Government/Public Debt

The amount of public debt a nation has is another key factor influencing its currency valuation. When governments engage in large-scale deficit financing to fund public projects, it can stimulate the economy in the short term. However, excessive public debt may deter foreign investment, as investors fear the potential for default. If a government appears unable to manage its debt responsibly, it could lead to a depreciation of its currency.

For instance - when a country faces fears of debt default, investors may sell off its bonds, leading to a fall in the currency’s value. Additionally, printing money to service debt can cause inflation, further weakening the currency. This exactly happened in the US during the time of Covid-19. ?US ?Federal Reserve (US Fed) printed trillions of dollars of currency notes and injected them into the commercial banking system, much like an electronic deposit.?By the end of the year 2020, the US Fed purchased an estimated $3.5 trillion in government securities?with these newly created dollars, one of many tools to prop up the ailing economy?during the COVID-19 pandemic, according to Oxford Economics.

5. Political Stability

Political stability is paramount for a currency’s strength. Investors are more likely to inject capital into countries with stable political environments. A stable government reduces the risk associated with investments, leading to an appreciation of the domestic currency. Conversely, political turmoil—such as sudden leadership changes or policy uncertainty—can diminish foreign investment and lead to currency depreciation.

For example – a serious political crisis in the UK started with the announcement of Brexit in 2016 following the resignation of David Cameroon, Theresa May, Boris Johnson, Elizabeth Truss and Rishi Sunak. The resignation of 5 prime ministers within a short span of 7 years caused great economic uncertainty in the UK and resulted in British Pound losing its value from USD 1.53 in 2015 to USD 1.28 in 2019 and USD 1.34 in 2024.

5. Economic Recession

Typically, a country entering a recession will see its currency depreciate. This is often due to falling interest rates, which can lead to capital outflows as investors seek better returns elsewhere.

For example: if Canada enters a recession, Canadian dollars (CAD) may be sold off as investors buy into currencies of countries with stronger economic prospects. However, the impact of a recession can be nuanced. In the event of a global recession, currencies of more stable economies—such as the US dollar—may remain strong as they are viewed as safe havens, even if those economies are experiencing challenges.

6. Terms of Trade

The Terms of Trade (ToT) reflect the relative prices of a country’s exports compared to its imports. When a country’s export prices rise faster than its import prices, it experiences an improvement in its terms of trade, leading to increased revenue from exports. This uptick typically enhances demand for the country’s currency, resulting in appreciation.

For instance, if a country exports commodities whose prices rise significantly on the global market while its import prices remain stable, this can bolster its currency’s value as foreign buyers exchange their currency for the nation’s currency to purchase those exports.

7. Current Account Deficits

The current account measures the balance of trade in goods and services and net income and transfers. Countries with significant current account deficits are typically seen as weaker economically, which can lead to currency depreciation.

For instance, if the UK has a higher current account deficit relative to Canada, it could weaken the Pound against the Canadian dollar. Conversely, countries with lower current account deficits usually enjoy stronger currencies, as they are perceived to be managing their economic resources more effectively.

8. Confidence and Speculation

Market sentiment plays a crucial role in currency valuation. Political events, economic indicators, and commodity price fluctuations can lead to speculation about future currency performance. For instance, if traders believe that the Eurozone will raise interest rates, they may buy Euros in anticipation of its appreciation. This speculative behaviour can drive up demand for the currency, increasing its value. Conversely, negative news or forecasts can lead to a sell-off, causing a currency to depreciate. Thus, trader psychology and market confidence can significantly influence currency exchange rates.

9. Government Intervention

Governments and central banks have the authority to intervene in foreign exchange markets to stabilize their currency. They may do this through monetary policies, such as adjusting interest rates or directly influencing the supply of currency. For example, the Chinese government maintains a lower value for the Yuan to promote exports and attract foreign investment. By keeping its currency artificially low, China can remain competitive in global markets.

Such interventions can create distortions in currency values but are often necessary for economic stability and growth, particularly in export-driven economies.

10. Stock Market Performance

The performance of a country’s stock market can also influence its currency value. A strong stock market typically signals a robust economy, attracting foreign investment. As foreign investors buy local stocks, they need to purchase the domestic currency, leading to increased demand and appreciation of that currency.

Conversely, a declining stock market may signal economic weakness, prompting investors to pull out their investments and return to their home currencies. This outflow can lead to currency depreciation.

The Impact of Currency Value on Consumers & Investments

Changes in currency values have significant implications for both investors and consumers. For investors, a depreciating currency can erode returns on foreign investments. A stronger currency, however, can increase the purchasing power of returns when converted back into the investor’s home currency.

• For consumers, currency fluctuations directly affect the prices of imported goods. A stronger domestic currency means that imports become cheaper, benefiting consumers.
• Conversely, a weaker currency can lead to higher prices for imported goods, impacting everyday expenses. Whether a strong currency is beneficial or detrimental depends on the context.
• For travellers, a strong currency means better value for purchases abroad. However, for domestic exporters, a strong currency can make goods less competitive in international markets, potentially harming profits. Moreover, countries with stronger currencies often see reduced tourism as visitors face higher prices. This complex interplay highlights that while a strong currency can reflect a robust economy, it can also create challenges in trade dynamics.

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