The exchange rate and value of a currency is determined by several factors, including inflation rates, political stability, foreign exchange policy, interest rates, and demand and supply.
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Exchange rates impact international trade, especially for a country that largely depends on importation and overall economic stability. Here are the most important factors that can influence the exchange rate market.
Economic policy
If a country that depends largely on importation suddenly takes a new direction by investing in local production and raising the bar on access to forex at the banks, manufacturers, who depend on importation of raw materials for production may be forced to source for forex at the alternative means such as parallel market.
There is nothing bad about emphasizing on local production, but it is more economically wise to fix all issues such as insecurity, poor road networks, erratic power supply before fully implementing local production policies.
Major challenges that may pose major challenges must be resolved so that to avoid a crisis in exchange rate to increase investors’ confidence.
Economic stability domestically and internationally can impact a currency’s value. Strong and stable economic policies can investor confidence, attract demand and international investment, and support the value of the national currency.
During uncertain times, safe-haven currencies such as the US dollar and Swiss franc can appreciate because investors store the value of their wealth in more relatively stable currencies.
Besides, the strength of a country’s currency is strongly influenced by economic conditions, such as growth in the Gross Domestic Product (GDP), consumer spending, and employment rates.
International trade
There is a trade surplus when exports exceed imports, but a country will most likely experience currency depreciation when imports exceed exports.
Importing more than exports technically means a country is using its local currency to buy foreign currencies to purchase foreign goods to meet local demands, the more this happens, the likelihood that the local currency depreciates.
However, governments can sometimes intervene in the market to stabilize their currency or obtain a competitive edge in international trade.
Central bank FX policy
For a country that has institutionalized black marketing in its foreign exchange such as Nigeria, any policy by the apex bank would have an impact on the exchange rate.
For instance the Central Bank of Nigeria (CBN) under the leadership of Godwin Emefiele on July 27, 2021, stopped the sales of forex to over 5,000 BDC operators due to sharp practices among operators, the decision affected the exchange rate market in Nigeria.
It’s not surprising to see the CBN claiming on its website that the official exchange rate was N411 when banks were selling at N450 or N480. This is what an economic professor described as Forex manipulation
Political Stability
Political instability during or after major elections or when politicians continue to hit up the policy may lead to currency depreciation due to higher risk perceptions.
Political instability and geopolitical conflicts affect Foreign Direct Investment (FDI) and affect investor sentiment and risk perceptions. For instance the economic value of most states in Nigeria have greatly been degraded because of kidnapping for ransom, ethnic violence, and other forms of insecurity, despite the large resources that abound in the region, which impact investment and the value of Nigeria’s currency.
Demand and supply factor
Supply of Dollars, Pounds, and Euros in the parallel market (which is one of the inventions of CBN in FX operation in Nigeria) was scarce due to the apex bank’s policy.
Hoarding followed, but the available ones at designated banks were insufficient. It led to rationing, though CBN assured that there was enough supply to the banks.
Fraudulent Nigerian travelers who jumped on the loopholes of the policy also made some millions within a few days by using fake visas to access PTA.
Interest Rates
Higher interest rates tend to draw in foreign capital, which raises demand for the home currency, making it more valuable than others.
Interest rate parity suggests that the difference in interest rates between two countries will determine their exchange rate. That’s why investors try to spot arbitrage possibilities in the foreign exchange market by monitoring the interest rate differentials and exchange rates.
Market Liquidity
Trading volume and market liquidity can influence exchange rates. More trading activity and liquidity in currency markets usually translate into exchange rate dynamics that are more efficient and stable.
Fiscal Policy
Another factor that may impact the value of a currency is the fiscal policy. When a government over-borrows, it puts its foreign reserves in jeopardy, thereby mounting pressure on the FX market back home.
This is one of the challenges the Buhari-led government faced between May 2015-May, thereby putting more pressure on the leadership of Nigeria’s apex bank, accused of defending Naira with foreign reserves
Limitations to forex
There is a limitation to how much you can access from the bank regardless of your need for forex.
Market Speculation
Traders and investors may speculate on currencies, which may result in brief changes in exchange rates. Body language of a president or a leading party’s manifesto may trigger market speculation. Geopolitical events, market sentiment, and assumptions about future economic conditions can influence speculative behavior.
For instance, President Bola Tinubu of Nigeria on assumption of office announced that he would not defend the naira and floated the local currency. The Naira/US Dollar rate within a year touched N1,700/USD before the CBN intervened again and it’s now below N1,300/USD (specifically N1,225/USD) at the time of publication.
Some FX traders who bought the dollar when the price was less than N700/USD, raked in millions of naira as profits while those who speculated that it would reach N2,000/USD are now counting their losses. Whether it is negative or positive for the speculators, market speculation is capable of influencing the value of a currency.
Inflation Rates
A higher inflation rate relative to other countries reduces the currency’s purchasing power. As a result, the currency depreciates. To protect the value of their investments, investors tend to look for currencies in nations with steady purchasing power.