Five factors that influence exchange rates
Foreign Exchange rate (ForEx rate) is one of the most important means through which a country’s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.
Background
Supply and demand dictate foreign exchange rates. For example, greater demand for British goods would see an increase in the value (appreciation) of the Pound. Markets worried about the future of the Eurozone economies would tend to sell Euros leading to a depreciation of the Euro.
What Influences Currency Exchange Rates?
Have you ever wondered how exchange rates are determined but were afraid to ask? As one of the leading factors behind the economic health level of any given country, exchange rates are one of the most analysed economic measures on the planet. But what exactly influences currency exchange rates and why are they so important to everyone from governments and large financial institutions to small investors?
Let’s now look at 5 common factors and explain how each has an influence on currency exchange rates:
Inflation
The rate at which the general level of prices for goods and services is rising is known as the inflation rate. If, for example, inflation were 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. Higher interest rates usually follow. Countries therefore with lower inflation rates will tend to see an appreciation in the value of their currency.
Zimbabwe's inflation rate (Zimbabwe Inflation Rates) as of January 2021 was at 362.63% and this is very high which decreases the purchasing power of the Zimbabwe dollar relative to other currencies. This has seen our currency depreciating though the Reserve Bank of Zimbabwe has tried to suppress the rate through the Foreign Exchange Auction System which was introduced in June 2020 and it is evident that they are not winning the fight. The other issue is that the local currency is non-convertible which means it can only be used primarily for domestic transactions and is not openly traded on a forex market.
Interest rates
There is also a high correlation between inflation, interest rates and exchange rates. Depositing money in the US for example becomes more attractive if US interest rates rise relative to other countries. By saving in US banks, a better rate of return will cause the demand for the dollar to rise. Central banks also can influence inflation and currency exchange rates by manipulating interest rates. If however the inflation rate is much higher in the US than in other countries, then, higher interest rates will have little impact in an appreciation of the dollar.
Zimbabwean banks have not been attractive for depositors to see motivation in depositing their funds due to less interest rates on deposits and also not getting the money when they need to withdraw and this has greatly affected the local exchange rate because demand for the local currency has been very low. Zimbabwe has been under recession which saw its interest rates fall thereby decreasing its chances to acquire foreign capital in the form of Foreign Direct Investment (FDI). As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.
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, we are more likely to see a rise in the valuation of the Euro as a result. Because a government’s reserve of foreign currency is quite low compared to daily turnover in the market, the power of speculators is quite significant in exchange rate influence.
In Zimbabwe the government announced laws without notice to the people which has made people lose their money before and now there is no trust hence the reason the black market has been booming compared to official exchange channels. Capture of state institutions by cartels has seen the central bank diverting funds which made people keep their funds at home. Zimbabwe has been prone to political confusion which saw a depreciation in exchange rates since the end of the Government of National Unity in 2013.
Balance of payments/current account deficit
If the value of imports is greater than the value of exports, this means there is a deficit in the current account. This deficit is a result of more spend on foreign goods and services by a given country than it is earning, and borrowing from foreign sources to make up the deficit is usually a feature. A lack of capital inflow to finance a current account deficit will inevitably lead to depreciation in the currency.
Zimbabwe has been under immense economic crisis which has seen Capacity Utilisation being projected at 27% as of 2020 by the Confederation of Zimbabwe Industries (CZI) if the government failed to change its policy direction. This has seen imports outweighing exports in reality though the Ministry of Finance and Economic Development reports surpluses on BOP but it doesn't show on the ground.
The country has been depending on diaspora remittances (Remittances and economic growth in Zimbabwe) for economic growth due to a crippled industry for production which is key in boosting exports.
=Public debt
A country’s debt rating is also a factor which has influence over 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.
According to the Reserve Bank of Zimbabwe (RBZ), the total debt stood at US$23.53 billion as at January 2019 which was not serviced. In February 2021, the government through the minister of Finance Mthuli Ncube gazetted a Statutory Instrument revealing that they had borrowed US$1.4 billion loans secured from African Export and Import Bank (Afreximbank) since 2017 reportedly for strategic imports and local currency support. These loans have been subject of debate with some stakeholders in Parliament querying how the money was secured and what it was used for.[1]
Zimbabwe has not had commercial relations with global lenders such as the International Monetary Fund, World Bank and African Development Bank over outstanding arrears, which accumulated when the economy went into a tailspin at the turn of the century. The authorities haven't been transparent to the lenders in terms of why they were failing to service the debt but always blamed sanction when it was evident that corruption was the main issue why the country is in this mess and haven't been transparent with the public on the level of the debt and its terms. The Creditworthiness of Zimbabwe is also a subject of contention.
