World Events and Currency
They are intrinsically linked….
As we have started to delve into the world of Forex or FX (and everything involved therein), we have begun to dip our collective toes into the waters of the FX seas. Testing the shallow end out before we dive headfirst into waters unknown.
So, to ease our readers and valuable clients into our world of FX we have started to broaden our focus – looking a little closer at what the world of FX is. We have discussed basic terminology and even went so far as discussing (at a high level) how the value of a currency is established (in our article Forex 101).
Now, with the water seemingly warm and no sharks lurking around, we figure it’s time to dive in a little deeper, take a swim in the vast FX ocean and learn a little more…. After all, the very purpose of our articles is to gift you with some industry knowledge, because at Kuda FX, we believe that knowledge is power.
So, come on in, the water is fine!
Kuda FX has you covered!
How is the value of a currency established?
As we discussed in our previous article (and as a quick refresher), the value of a currency is established through the aggregate of supply and demand, which is – often times – influenced by a number of different factors.
But the most common way to value a currency remains through its exchange rates.
Exchange rates can be either fixed (set to a pre-established standard such as gold) or floating (which allows the foreign exchange market determine currency value with respect to the supply and demand of other currencies). Exchange rates therefore play a critical role in how a country is able to trade – or more specifically – how much or how little they are able to trade.
And the ability to “trade” friends, is vital to most, if not all free market economies in the world.
Why is this important?
Well, with the majority of the world’s major currencies on a floating exchange rate, currencies will be affected by more than just supply and demand. Factors like the economic actions of its government or the role of central banks. There is also interest rate parities and geopolitical events. Macroeconomic events. And the inevitable take away from this – and the point of this article? These factors will have an impact on exchange rates. And we believe that they are worth looking at… wouldn’t you say?
Because macroeconomic events globally will play a greater role in FX than they did during the time of the Gold Standard or even the Bretton Woods System. Because it’s no longer as simple as keeping an eye on the “popular” currencies to see whether there is a change in the supply or demand. One needs to consider all surrounding circumstances to gain a clearer (more accurate) view.
Factors that will have an impact on the value of currencies
Before we jump right in, it’s worth mentioning that as an exchange rate moves – either up or down – it will affect how one country trades with another. It makes sense if you think about it. A currency with a higher-value currency results in that country’s imports being less expensive but its exports being more expensive in other markets – and vice-versa.
Higher valued currencies actually negatively impact a country’s global trade. So the insinuation here is that having a low exchange rate can actually improve trade relations.
But is it really that simple?
According to the International Monetary Fund, inflation –
“measures how much more expensive a set of goods and services has become over a certain period, usually a year”.
And because of this measurement of expense, countries have been plunged into periods of immense instability….. but how does it affect exchange rates?
Well, a country with a lower inflation rate exhibits a rising currency value – simply because its purchasing power increases in relation to other currencies. Countries with higher inflation rates will – usually – see depreciation in their currency for the opposite reason – their purchasing power decreases.
A simple example is this – if inflation in the US is lower than their trading partners, then US exports will become more competitive. And this will inevitably result in an increase in demand for the US$, in order to buy US made goods. Foreign goods will become less desirable and less competitive as Americans purchase fewer imports, rather spending their hard-earned cash on locally made goods. And again, that makes economic sense.
The takeaway here – countries with a lower inflation rate often (but not always) see an appreciation in the value of their currency.
For interests sake – South Africa’s current inflation rate (measured by CPI) is 7% (Stats SA), compared to the UK with an inflation rate that unexpectedly edged higher to 10.4% in February 2023 (Trading Economics) and the US with a current inflation rate of 6.0% (US Inflation Calculator).
With this in mind – remembering that a lower inflation rate is more desirable – it would seem that (naturally) the US$ is leading the currency pack. With South Africa following – seemingly – close behind.
But is that really the case?
According to Investopedia, an interest rate –
“is the amount charged on top of the principal by a lender to a borrower for the use of assets. An interest rate also applies to the amount earned at a bank or credit union from a deposit account.”
So, it is an amount of money paid over and above (or earned over and above) an amount borrowed (or saved).
There is one thing we want to highlight though – exchange rates, inflation and interest rates are all closely related. And let us explain why –
When central reserve banks manipulate their interest rates, there is a heavy impact on both inflation and exchange rates. Simultaneously. And if you recall, a changing interest rate will have an impact on inflation which will then have an impact on currency values. Because it’s all linked!
The benefit of having a higher interest rate? Lenders in an economy will have a higher return compared to other countries. And this means – foreign capital pours into the country, causing exchange rates to rise. Because foreign investors have confidence in the value of the currency and their potential rate of return should investments be made.
With more demand and a higher return on lending, it makes sense. It’s almost like a quid pro quo kind of relationship.
And vice versa. If interest rates decrease, exchange rates – as a result – tend to decrease.
As an example – if the interest rates in the UK are higher in relation to other countries, it becomes more attractive to deposit money in the UK as you will get a better rate of return from saving money in a local UK bank. As result, the demand for Sterling increases. So on and so forth. A knock-on effect if you will.
For interests sake – South Africa’s prime rate is at 10.75% (CEIC). While “The Bank of England raised its key bank rate by 25bps to 4.25% during the March 2023 meeting, in line with expectations, and pushing borrowing costs to fresh 2008-highs, aiming to bring inflation back to the 2% target (Trading Economics). Meanwhile in the US, the prime rate is 8% (Forbes Advisor).
On that basis alone it would seem that South Africa is once again attractive for saving money, closely followed by the US.
Or so it would seem…
Like in the ordinary course of business, having a positive bank balance is always preferred. And the same can be said when discussing trade between countries. The relationship between one country with all its trading partners should reflect a positive balance in so far as all payments between countries for goods, services, interest, and dividends (which will sit in their “current accounts”) is concerned.
A deficit in this trade current account reflects that a country is spending more than it’s earning – and probably borrowing capital from foreign sources to make up for the deficit. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, while foreign assets become too expensive to generate sales for domestic interests (because locals simply don’t have the money to stimulate the GDP).
And that makes a country less appealing – regardless of other perks.
For interests’ sake – South Africa recorded a trade deficit of “R23.05 billion in January 2023. Despite recording a full-year total trade surplus of R211.6 billion (exports of R2.02 trillion and imports of R1.81 trillion) in 2022, South Africa is importing more than it was exporting at the start of 2023” (Business Tech). And that is not a good thing where the value of the Rand is concerned.
As one can imagine, having a hefty trade deficit will inevitably result in a country having to engage in large scale deficit financing (or borrowing) to pay for public sector projects and governmental funding. In other words, a country – just like an ordinary everyday person – is indebted and as such needs to take out a loan to pay for that debt.
As we all know – at least for a person – hefty loans to pay off debts can affect a person’s credit rating (the advert for Clear Score may be coming to mind right about now). The exact same thing can be said for a country. Just on a larger scale.
While large scale deficit financing can stimulate the domestic economy, if there are large deficits and debts present (like with South Africa), suddenly the grass does not look as green on that side of the fence – especially to foreign investors. You see, a large debt encourages inflation, which in turn means that the debt will be paid off with an even lower valued currency in the future and that means paying off the debt will take much longer.
And again this will have a knock-on effect – higher inflation, lower currency value, lower exchange rate. Etcetera ad infinitum.
Imports vs exports
If the value of a country’s exports rises by a higher rate than that of the items it’s importing, that naturally infers that trade has improved.
This “measure of trade” is referred to as terms of trade – the comparison of export prices to import prices.
A positive term of trade would mean that there’s a demand for a country’s exports. And that means, as a result, a country will earn more revenue resulting in an increased demand for that country’s currency (and therefore an increase in that currency’s value).
If the price of exports rises by only a small rate compared to that of its imports, the currency’s value will decrease in relation to its trading partners. And that is evident with South Africa importing more than it was exporting in 2022.
With all the above information in mind, it stands to reason that inflation, interest rates, trade deficits, debts and terms of trade would have an effect on the overall economic health of a country’s economy.
And this is a primary factor in the exchange rate of its currency. Overall economic health can change on a daily basis depending on current events. Take for example the fact that South Africa has a trade deficit recorded of R23.05 billion (Business Tech) or that Eskom – with its continuous loadshedding (“pushed to Stage 3 back to Stage 5 tomorrow”) creates fear, uncertainty and doubt in the minds of foreign investors, reducing investor confidence in the South African economy and ultimately impacting how the Rand is valued.
Or to add to our economic health woes, the fact that a warrant of arrest has been issued by the International Criminal Court for Russian President Vladimir Putin (Aljazeera), a few weeks after South Africa held joint military exercises with Russia and China (BBC). Adding further proverbial fuel to the fire is the fact that news headlines currently read “Russian President Vladimir Putin is welcome to visit South Africa” (EWN).
None of these political issues stand in favour of the South African Rand.
Who you get into political bed with, irrespective of your favourable interest rates or inflation, will affect foreign investment, trade and confidence in a country’s stability (as we have seen with S & P unexpectedly downgrading South Africa’s credit rating outlook to stable from positive according to News24). And this, ultimately, will result in the lowering of the value of the currency.
As set out by Investopedia –
“The forex market is primarily driven by overarching macroeconomic factors. These factors influence a trader’s decisions and ultimately determine the value of a currency at any given point in time”.
And South Africa is particularly problematic. Not only are there economic and social challenges mounting, but trade and industry risks stagnation amid an unprecedented energy crisis. And this only further exacerbates infrastructure and logistics bottlenecks (IMF).
South Africa has – seemingly – become a less favourable environment for foreign investment. At least on the face of it. There is a quote from Finance Minister Enoch Godongwana’s budget speech that we feel has application here –
“Our economy is facing significant risks. Uncertainty is on the rise. It requires us to do bold things. To put the fear of failure aside and execute the difficult trade-offs needed to get from where we are now, to where we want to be in the future.”
As we hope our article sets out – there are far more complex factors that affect how a currency is valued. Everything is interlinked and a negative occurrence in the political arena, or a trade deficit or hefty debt can far outweigh the benefits of other factors. Macroeconomic factors must be considered. Always!
It’s a definitive weighing of the scales to see what is more favourable – at least for you. Keeping in mind that there may be risks involved, that there may be uncertainty and that it will require boldness and bravery to make a sound decision where your money – whether it be FX or not – is concerned.
So, with this in mind, we encourage you to get in touch with a FX professional, like our team at Kuda FX who would be happy to explain the above concepts in further detail or provide any other assistance you may require with your specific FX needs.
In fact, if you have any queries on the information we have set out above, please feel free to get in touch with us.
We look forward to helping you with all your forex needs!