Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. Numerous factors influence exchange rates, including a country's economic performance, the outlook for inflation, interest rate differentials, capital flows and so on. A currency's exchange rate is typically determined by the strength or weakness of the underlying economy. As such, a currency's value can fluctuate from one moment to the next.

Key Takeaways

  • Currency exchange rates can impact merchandise trade, economic growth, capital flows, inflation and interest rates.
  • Examples of large currency moves impacting financial markets include the Asian Financial Crisis and the unwinding of the Japanese yen carry trade.
  • Investors can benefit from a weak greenback by investing in overseas equities. A weaker dollar can boost their returns in U.S. dollar terms.
  • Investors should hedge their foreign currency risk via instruments such as futures, forwards and options.
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Effects Of Currency Fluctuations On The Economy

Far-Reaching Currency Impacts

Many people do not pay attention to exchange rates because rarely do they need to. The typical person's daily life is conducted in their domestic currency. Exchange rates only come into focus for occasional transactions, such as foreign travel, import payments or overseas remittances.

An international traveler might harbor for a strong domestic currency because that would make travel to Europe inexpensive. But the downside is a strong currency can exert significant drag on the economy over the long term, as entire industries are rendered noncompetitive and thousands of jobs are lost. While some might prefer a strong currency, a weak currency can result in more economic benefits.

The value of the domestic currency in the foreign exchange market is a key consideration for central banks when they set monetary policy. Directly or indirectly, currency levels may play a role in the interest rate you pay on your mortgage, the returns on your investment portfolio, the price of groceries at your local supermarket, and even your job prospects.

Currency Impact on the Economy 

A currency's level directly impacts the economy in the following ways:

Merchandise Trade

This refers to a nation's imports and exports. In general, a weaker currency makes imports more expensive, while stimulating exports by making them cheaper for overseas customers to buy. A weak or strong currency can contribute to a nation's trade deficit or trade surplus over time.

For example, assume you are a U.S. exporter who sells widgets at $10 each to a buyer in Europe. The exchange rate is €1=$1.25. Therefore, the cost to your European buyer is €8 per widget.

Now let's say the dollar weakens and the exchange rate is €1=$1.35. Your buyer wants to negotiate a better price, and you can afford to give them a break while still clearing at least $10 per widget. Even if you set the new price at €7.50 per widget, which is a 6.25% discount from your buyer's perspective, your price in dollars is $10.13 at the current exchange rate. A weak U.S. dollar allows your export business to remain competitive in international markets.

Conversely, a stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, export-dependent industries can be damaged by an unduly strong currency.

Economic Growth

The basic formula for an economy’s GDP is:

GDP=C+I+G+(XM)where:C= Consumption or consumer spending, the biggestI=Capital investment by businesses and householdsG=Government spending(XM)=ExportsImports, or net exports\begin{aligned} &GDP= C + I + G + (X-M)\\ &\textbf{where:}\\ &\begin{aligned} C = &\text{ Consumption or consumer spending, the biggest}\\ &\text{ component of an economy}\end{aligned}\\ &I = \text{Capital investment by businesses and households}\\ &G = \text{Government spending}\\ &(X-M) = \text{Exports}- \text{Imports, or net exports}\\ \end{aligned}GDP=C+I+G+(XM)where:C= Consumption or consumer spending, the biggestI=Capital investment by businesses and householdsG=Government spending(XM)=ExportsImports, or net exports

From this equation, it is clear that the higher the value of net exports, the higher a nation's GDP. As discussed earlier, net exports have an inverse correlation with the strength of the domestic currency.

Capital Flows

Foreign capital tends to flow into countries that have strong governments, dynamic economies, and stable currencies. A nation needs a relatively stable currency to attract capital from foreign investors. Otherwise, the prospect of exchange-rate losses inflicted by currency depreciation may deter overseas investors.

There are two types of capital flows: foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities in the recipient market; and foreign portfolio investment, in which foreign investors buy, sell and trade securities in the recipient market. FDI is a critical funding source for growing economies such as China and India.

Governments generally prefer FDI to foreign portfolio investments, because the latter is hot money that can leave the country quickly when conditions grow tough. This capital flight can be sparked by any negative event, such as a devaluation of the currency.

Inflation

A devalued currency can result in "imported" inflation for countries that are substantial importers. A sudden 20% decline in the domestic currency could result in imports costing 25% more, as a 20% decline means a 25% increase is needed to get back to the original price point.

Interest Rates

As mentioned earlier, exchange rates are a key consideration for most central banks when setting monetary policy. In September 2012, Bank of Canada governor Mark Carney said the bank took the persistent strength of the Canadian dollar into account when setting monetary policy. Carney said the Canadian dollar's strength was one reason why his country's monetary policy had been "exceptionally accommodative" for so long.

A strong domestic currency exerts drag on the economy, achieving the same result as a tighter monetary policy (i.e. higher interest rates). In addition, further tightening of monetary policy at a time when the domestic currency is already strong may exacerbate the problem by attracting hot money from foreign investors seeking higher yielding investments (which would further strengthen the domestic currency).

Global Impact of Currencies: Examples

The forex market is the most actively traded market in the world, with an excess of more than $5 trillion traded daily, far exceeding global equities. Despite such enormous trading volumes, currencies usually stay off the front pages. However, there are times when currencies move in dramatic fashion and the reverberations are felt around the world. We list below a few examples:

The Asian Crisis of 1997-98

A prime example of the havoc caused by adverse currency moves is the Asian Financial Crisis, which began with the devaluation of the Thai baht in summer of 1997. The devaluation occurred after the baht came under intense speculative attack, forcing Thailand's central bank to abandon its peg to the U.S. dollar and float the currency. This currency contagion spread to neighboring countries such as Indonesia, Malaysia and South Korea, leading to a severe contraction in these economies as bankruptcies soared and stock markets plunged.

China's Undervalued Yuan

Between 1995 and 2005, China held the renminbi steady at about 8.2 per dollar, enabling its export juggernaut to gather steam from what trade partners said was an artificially suppressed and undervalued currency. In 2005, China responded to the growing chorus of complaints from the U.S. and other nations. It allowed the yuan to steadily appreciate, from over 8.2 RMB to the dollar to about 6 per dollar by 2013.

Japanese Yen's Gyrations From 2008 to Mid-2013

The Japanese yen was one of the most volatile currencies between 2008 and 2013. Because of Japan's policy of near zero-bound interest rates, traders favored the yen for carry trades, in which they borrowed yen for next to nothing and invested in higher yielding overseas assets. But as the global credit crunch intensified in 2008, the yen began appreciating sharply as panicked investors bought the currency in droves to repay yen-denominated loans.

As a result, the yen appreciated by more than 25% against the U.S. dollar in the five months to January 2009. Then in 2013, Prime Minister Shinzo Abe unveiled monetary stimulus and fiscal stimulus plans (nicknamed "Abenomics") that led to a 16% plunge in the yen within the first five months of the year.

Euro Fears (2010-12)

Concerns that the deeply indebted nations of Greece, Portugal, Spain and Italy would be forced out of the European Union led the euro to plunge 20% from 1.51 to the dollar in December 2009 to about 1.19 in June 2010. The euro recovered its strength over the next year, but that only proved temporary. A resurgence of EU break-up fears led to a 19% slump in the euro from May 2011 to July 2012.

How Can an Investor Benefit?

Here are some suggestions to benefit from currency moves:

Invest Overseas

US-based investors who believe the greenback is weakening should invest in strong overseas markets, because your returns will be boosted by foreign currency gains. Consider the Canadian S&P/TSX Composite Index between 2000 and 2010. The S&P 500 Index was virtually flat over this period, yet the TSX generated about 72% returns in Canadian dollar terms. For U.S. investors buying Canadian equities with greenbacks, U.S. dollar returns were about 137%, or 9% per annum, due to the steep appreciation of the Canadian dollar.

Invest in U.S. Multinationals

The U.S. has many large multinational companies that derive a substantial part of revenues and earnings from foreign countries. Earnings of U.S. multinationals are boosted by the weaker dollar, which should translate into higher stock prices when the greenback is weak.

Refrain From Borrowing in Low-Interest Foreign Currencies

This has admittedly not been a pressing issue since 2000, as U.S. interest rates have been at record lows for years. However, at some point they will rise again. When that happens, investors who are tempted to borrow in foreign currencies at lower interest rates should remember those who had to scramble to repay borrowed yen in 2008. The moral of the story: never borrow in a foreign currency if it is liable to appreciate and you do not understand or cannot hedge the exchange risk.

Hedge Currency Risk

Adverse currency moves can significantly impact your finances, especially if you have substantial forex exposure. But there are plenty of choices to hedge currency risk, such as currency futures, currency forwards, currency options and exchange-traded funds such as the Invesco Euro CurrencyShares Euro Trust (FXE) and Invesco CurrencyShares Japanese Yen Trust (FXY).  Consider these options if you like to sleep at night.

The Bottom Line

Currency moves can have a wide-ranging impact on a domestic economy and globally as well. When the greenback is weak, investors can take advantage by investing overseas or in U.S. multinationals. Because currency moves can be a potent risk when one has a large forex exposure, it may be best to hedge this risk through the many hedging instruments available.