Globalization and the growing interconnectedness among nations have necessitated trade and other forms of partnership between countries.
Since the dawn of the 20th century, nations have rapidly removed barriers of international trade. This practice has entrenched free trade among nations. North America now has NAFTA, Europe has the E.U agreement, while just recently African countries signed ACFTA which guarantees free trade among nations in the different continents.
But what currency do these nations use to trade in the international market? And how do they acquire these currencies? Answers to these questions will lead us to terms known as foreign exchange and exchange rate.
Foreign exchange basically is the conversion of one currency to another. When a business person travels to buy goods from another country, he converts his home country’s currency to the other country’s currency since his currency is not a legal tender in that country.
The exchange in currency for the purpose of trade is what we call foreign exchange.
What are Exchange Rates and How They are Decided?
Foreign exchange is similar to an ancient form of trade prominent in Africa known as barter. In this trade, goods were exchanged for each other.
For example, if I have 1kg of rice and need 1kg of flour, I can simply do a swap with someone who needs 1kg of rice.
But if the demand for flour is higher than that of rice, and there isn’t enough supply of flour in the market, I will have to part with more rice to get flour. If I give 1kg of rice to get half kilogram of flour, then the exchange rate of rice for flour 1kg to half kilogram.
The illustration above is similar to what obtains in the foreign exchange market.
Forex Brokers South Africa explains that “Exchange rate basically is the value of one currency relative to another. What this means is that exchange rate is the value of a country’s currency when compared to another. For example, the exchange rate of the naira to the U.S dollar is N410/1 USD. This means that a Nigerian importer will need to part with N410 for every $1 they need.”
“A weaker exchange rate can be advantageous for an export economy, so central banks try to maintain a weaker currency artificially through theirExchange Rate policy. But a very weak currency can also lead to high inflation.”
Questions we will try to answer here include why does one country have a more valuable currency to another? In the 1970s and early 1980s, the naira traded against the U.S dollar at 90kobo/1dollar and at sometimes it was on par with the U.S dollar.
The reason for the fall in the value of the naira against other currencies is universal. It can apply to any other country that toes the same fiscal policy lane.
Exchangesgo a long way to determine the state of a nation’s economy.
They can be fixed or as in recent times floated. Fixed exchange rate is usually decided by the country’s central bank while those that are floated are decided by market forces of demand and supply.
This brings us to the factors responsible for currency fluctuation or volatility against others.
Causes of Exchange Rate Fluctuation
There is no time in the foreign exchange market where the value of a currency is stable. This is due to the fact that most of them are floated and are subject to various factors. The causes of currency fluctuation include;
- Inflation/Interest Rates: the increase in price of goods and services has a way of influencing the value of a country’s currency. A relatively slow-paced increase in price of goods is indicative of a healthy economy which strengthens the value of a country’s currency. While rapid increase in inflation decreases the value of a country’s currency. Interest rate and inflation are intertwined as far as the value of a country’s currency is concerned. As inflation increases, a country’s central bank can decide to raise interest rates to curb the inflation, prevent citizens from access to loan facilities and attract foreign capital. All these leads to an increase in exchange rate.
- Balance of Trade: balance of trade refers to the difference between the value of a country’s total export and its total import. There is need for conversion of currencies in the international market. If a country has a positive balance of payment, it means that she exports more than she imports. This increases the value of her currency because she spends less of her currency in the international market. But if the balance of trade is negative, the country will need to give in more of her currency in the foreign exchange market. This creates a deficit which reduces the value of her currency. Most countries do borrow from international lenders to shore up their balance of trade deficit. The culminates in more economic woes.
- Socio-political and Economic Condition: countries with strong economic performances will attract foreign investment which boosts the value of its currency. However, in periods of recession, where the economy falls, the currency of a country always takes a hit. Political turmoil, riots and social instability makes investors leave a country. It also prevents investment from foreign investors. This capital flight and lack of investment usually takes its toll on the value of a country’s currency. It will shed some of its value when compared to other countries with stable socio-economic and political conditions.
- Public Debt: a country will large public debt especially to international lenders will usually use more of its revenue for debt servicing. When this is done, inflation usually increases. Increased inflation usually scares foreign investors. This has a negative effect on the currency of the country as it weakens when compared to its counterparts from countries without large public debt.
- Monetary Policy: the central bank of any nation is the engine room of any country’s economy. The potency of its monetary policy goes a long way to determine the value of that country’s currency. The level of regulation of the amount of money in circulation influences the value of the money. Too much money in circulation or too little money, interest rate, minimum wage etc. all have effects on the exchange rate of a country’s currency.
Other causes of exchange rate fluctuation are; speculation, government intervention, and confidence.
Effects of Exchange Rate Fluctuation on Economy and Trade
To a layman on the street, exchange rate only affects governments and big business men especially importers.
But it has been said exchange rate is an indicator of the health of a country’s economy. Exchange rate fluctuation have both micro and macro-economic implications.
On the macro-economic front, can lead to inflation especially in a country with negative balance of trade.
Since importers will be paying more of their currency to get that of the other country. This increases price of goods and reduces consumer purchasing power as income remains stable.
The ripple effect of this is company’s and businesses will not meet their expected sale’s figures or might make losses. This can lead to jobs losses as businesses seek to cut down on cost.
Exchange rate fluctuation can make a country pay more or less to service external debt. For example, if Nigeria borrows $1million from a U.S bank at 3percent interest rate per annum at an exchange rate of N410 per U.S dollar.
If after one year, the exchange rate has changed to N500 per dollar. It means instead of Nigeria paying four hundred and twenty-two million naira in return, the government will pay five hundred and fifteen million Naira. A loss of ninety-three million due to exchange rate fluctuation.
On the other hand, a weaker exchange rate can attract foreign investors, and creates job opportunities. All these can help boost a company’s trade balance due to weaker currency.
On the micro-economic front, exchange rate fluctuation can make Small and Medium Scale Entrepreneurs (SMEs) either make profit or incur losses. This is truer for those who rely on imported materials for production of goods. Exchange rate fluctuation can also lead to increased individual borrowing or increased savings depending on the balance of trade of the country.
Exchange rate fluctuation can also has damning effects on individuals seeking for services abroad if they come from a country with a weak currency. Such services include health, education, entertainment etc. Citizens of a country will have to pay more or less depending on the value of their country’s currency.
For those receiving remittances, exchange rate fluctuation also affects the value of money one receives in return after converting to his home currency.
In summary, the value of a country’s currency sits at the heart of a country’s economic well-being. A weak or dead currency signifies a weak or dead economy.