Currency values are in constant flux, regularly going up and down in value. Five years ago, $1AUD was worth $0.90 USD. Today it’s worth $0.68 USD.
However, this isn’t entirely random and there are factors that affect its performance. In this post we examine five factors that influence currency value.
1. Interest rates
Australia’s interest rates are set by the Reserve Bank of Australia (RBA).
If interest rates are increased, holding that nation’s currency generates higher interest payments, creating more opportunities for profit growth. This draws in traders who try to buy it up, increasing the price of the currency.
Conversely, if the rates are decreased, opportunities for profit decrease and the currency is considered less valuable, causing people to try sell it off. With falling demands, the currency’s price falls.
2. Economic stability
A stable economy is perceived as low risk, attracting foreign investment. This demand increases the price of its currency.
In contrast, a weaker economy leads to investors losing confidence and withdrawing their investments, leading to the currency dropping.
3. Trade-Weighted Index
The trade-weighted effective exchange rate index (TWI), a common form of the effective exchange rate index, is a multilateral exchange rate index. It is compiled as a weighted average of exchange rates of home versus foreign currencies, with the weight for each foreign country equal to its share in trade.
When exports outweigh imports, an economy is said to have a ‘trade surplus’, strengthening the stability of said economy. The currency value rises as foreign consumers buy the currency to purchase exported goods.
On the other hand, when imports are greater than exports, an economy experiences a ‘trade deficit’. The country must sell its own currency to purchase the imported goods, leading to a reduction in currency value.
The TWI is a way of measuring the above in one simple number.
4. World events
Geo-political events, crisis, and impending election can all affect the strength of a currency based on how that affects the perception of a country’s stability. A positive event can attract foreign investors, with a rise in foreign capital increasing the value of the currency. A country in crisis can lead to a loss of confidence and depreciation of its currency value.
5. Government debt
Government debt by itself not necessarily a negative. It can help improve local infrastructure and creative economic growth. However, when it is too high, it can lead to inflation and currency devaluation.
When public debt is reduced, the economy becomes more stable and again attracts more investors, increasing the value of the currency. If public debt increases, the government may issue more currency, increasing the volume in circulation (known as quantitative easing). This dilutes the value of existing currency holdings, causing prices to drop.