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The exchange rate is one of the most important determinants of a country's relative level of economic health. It plays a vital role in trade, which is critical to most free market economies. But exchange rates matter on a smaller scale too. They even impact the real return of an investor's portfolio.  Here we’ll look at the main factors influencing exchange rates.

Factor 1: Differentials in Inflation  

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency's value in relation to the currencies of their trading partners.

Factor 2: Differentials in Interest Rates

By manipulating interest rates, central banks exert influence over both inflation and exchange rates.  Higher interest rates offer lenders a higher return relative to other countries. The impact of higher interest rates is mitigated, however, if a country's inflation is much higher than other countries', or if additional factors serve to drive their currency value down. The opposite relationship exists for decreasing interest rates. 

Factor 3: Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows a country is importing goods and services more than it is exporting them. The country will then typically borrow capital from foreign sources to make up the deficit, causing its currency to depreciate relative to its trading partner. 

Factor 4: Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects using governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. This is because a large debt encourages more inflation, and higher inflation translates into lower currency value.

Factor 5: Terms of Trade

A country's terms of trade is a ratio comparing export prices to import prices. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved, which tends to show currency appreciation.  However, if the price of a country's imports rises more than the rate of exports, their currency's value will decrease in relation to trading partners.

Factor 6: Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. Political turmoil, for example, can cause a loss of confidence in a currency, and a movement of capital to the currencies of more stable countries.

The Bottom Line

The return of a portfolio that holds currency is affected by that currency's exchange rate. Moreover, the exchange rate is highly correlated to other income factors, such as interest rates, inflation and even capital gains from domestic securities.

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