How currency exchange (FX) rate works?

After my post on money, I was trying to understand how exchange rate works and how it is controlled or managed by central bank of the country. This post will make you understand the basics of currency exchange rate. Actually I was about to post on the topics of falling crude oil prices and start up boom but because of other commitments I am not able to make it and soon I will post on those topics also. By the way, Happy New Year to everyone and this is the first post in this year.

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Below were the questions in my mind and I am repeating those questions here so that it will be easy for the viewers to get a clear idea about the agenda of this post.

  1. Does higher exchange rate means stronger economy?

I USD = 66.50 INR

1 USD = 6.4 CNY

1 USD = 122 Yen

1 USD = 36 THB

1 USD = 71 RUB

Conversion rate of USD to THB is less compared to USD-INR rate. Then is it true that the Thailand economy is stronger than India? In the same way, is it rite to say Indian economy is stronger than Russian economy by looking at the exchange rate? By looking at the exchange rate we cannot say which country economy is strong. We will look in more detail about this later.

  1. What are the factors affecting exchange rate?
  2. Who manages exchange rate?
  3. What is the relationship between exchange rate and interest rate? Once US FED increased interest rate, USD is getting stronger against the major currencies of the world.
  4. Is there any relationship between inflation and exchange rate?
  5. How central bank manages exchange rate of the country?
  6. In 2015, we were keep on hearing China’s devaluation of its own currency? How they able to achieve that easily? Why China keep on buying US debt? Why they are pegging against US dollar?
  7. Why Indian rupee (INR) keep on depreciating and Indians are worrying about this? But in China they are devaluating the currency overnight easily. Why India is not doing like this?

First let us get into the basics so that it will be easy to understand the concepts

What is exchange rate?

Exchange rate of the currency represents the value of its money in international trade. In other words, exchange rate is a price of a currency stated in units of another currency,

1 USD = 67 INR

1 USD = 6.4 CNY

Why exchange rate exists?

Exchange rates exist because countries have to exchange their national currencies with foreign currencies to engage in trade (buy and sell of commodities) and financial transactions with other countries.

Most of the international trades and transaction will happen in USD, EURO, POUNDS, YEN and FRANC. These currencies are called as IMF Reserve currencies and even Chinese Yuan will be part of reserve currency basket. Every central bank of country maintains these currencies as foreign reserves.

What is domestic and foreign currency?

Let’s us say a person lives in India then

Domestic currency – INR

Foreign currency – Other currencies USD, YEN etc.

Why international trades is happening in reserve currencies not using the country domestic currency?

In today’s world there are almost 180 fiat currencies exists. If every country settle the cross border trade using their domestic currencies then international trade becomes more complicated. To explain this let me give an example

Country A produces surplus wheat – INR

Country B produces surplus oil – USD

Country C produces surplus rice – THB

Country D produces surplus cotton – YEN

Country A needs oil and Country B needs wheat hence both countries happily exchange their domestic currencies for their cross border trade. Country C requires oil but country B does not require rice because they able to produce in their country hence country C finds difficult to get oil. Because of this reason only people invented money and now again same problem in international trade. Basically if both countries needs some commodities to exchange then there is no problem in exchanging domestic currencies but if they don’t then there is problem.

Hence they need universal currency to address this issue. Majority of the international trade in today’s world is happening through USD and the rest is by other reserve currencies like Pounds, Yen etc. I am not here to explain why USD is reserve currency (to know more about this refer my post on “Bretton woods system – How money is created”).

What is FX market?

FX market is a place where all the currencies are bought and sold. FX market is not exchange traded i.e.) it is traded over the counter by commercial banks, central banks, FX brokers, institutional clients etc. Major participant in this market are the larger international banks. Size of the market is very big and transaction size is about $5 trillion per day.

What are the factors affecting exchange rate?

Currency also follows basic economics model i.e.) demand-supply policy.

If there is more demand on domestic currency in FX market then domestic currency gets stronger against foreign currency.

1 USD = 67.50 INR

If there is more demand on INR against USD, then INR becomes stronger. Then exchange rate may become

1 USD = 67.20 INR

Domestic currency demand may get increase in the following cases

  1. Exports

For example, Indian manufacturer exports his items to a buyer in US, Indian exporter receives the payment for his export in US$. Therefore, if the Indian exporter is to use his US$ income in India, he has to sell his US$ (foreign currency) proceeds to a bank for INR (domestic currency). This will make the Indian currency stronger. Similarly if Indian importers have to buy USD for payments to suppliers then INR may get weaker. Thus Indian currency becomes weaker if there is more sell of domestic currency when compared to buy of domestic currency.

  1. Remittance from abroad

Citizen who is working outside the country may send foreign country money back to his home country for personal needs like family expenses and investments. This involves buying of domestic currency using foreign currency (selling of foreign currency and buying domestic currency). Demand increases on domestic currency because of remittance. To more about remittance, refer my post on Remittance.

  1. Foreign investments inflow

Foreign investment involves buying of domestic currency hence it creates demand for the domestic currency.

  1. Foreign borrowings

Individuals or banks borrow money from foreign banks or individuals and this create demand on domestic currency when they try to convert foreign currency to domestic currency.

If there is more demand on foreign currency then domestic currency gets weaker against foreign currency. Following are the cases where foreign currencies demand will be higher than domestic currencies.

  1. Imports are high compared to exports.
  2. Foreign travel – It will increase the demand of foreign currency.
  3. Foreign investments outflow – Foreigners taking their money back to the home country.
  4. Foreign loan payments.

Interaction between demand for and supply of a particular foreign currency against the domestic currency will determine the exchange rate of the foreign currency in the country. The demand will have an upward pressure on the value of the foreign currency and supply will have a downward pressure. The increase in the value of a currency against another currency is termed as appreciation of the currency whereas a decline in the value is the depreciation of the currency.

In addition to the above factors there are few other micro economic factors like

  1. Inflation
  2. Interest rate of the country

Before explaining inflation and interest rate let me explain important thing here so that it is easy to understand inflation.

If money is everything, why can’t central bank print more money and make everyone rich?

To explain this, let me give an example so that it will be easy to understand.

Let us assume there are three sons in a family, mother told I will give 1 slice of bread if you earn 1$. They lived happily by working hard and giving the earning to mom.

Now cost of bread is 1$

After a month each son got wage increase in their work and their salary becomes 2$. Even now also mom is able to make three slices of bread only and son is giving 2$ for bread slice. If not other brother will give 2$ and eat two breads. Mom does not want any son to sleep in hunger, so  mom decides to increase the price to 2$ so that everyone will get equal share. Just assume mom cannot make more bread slice in this example.

Now cost of bread is 2$

This is called inflation. Inflation means your money will buy less quantity of goods in economy. In the above example, same bread costs 2$. Hence printing money alone will not make you rich and it just inflates the money in economy. Actually production needs to be increased in the economy along with money supply else it will simply create inflation.

By the above example you can understand that increase in money supply alone will not solve the needs in economy. Actual production needs to get increased along with money supply then only money becomes valuable in economy.

Just replace mother with country and sons as citizens then you can visualise the economy.

In the above example just assume, sons got more wage increase to 10$ and their workload also doubled in the workplace. They need more food to make sure they are more fit and healthy. Hence all three sons decided to  import bread from nearby country but the selling country demanded more money for bread (1 slice for 3$). Now because of money supply, inflation happened and in turn induces import. As we already discussed if there is more import compared to export then exchange rate falls for the country.

Now again going back to story

Country A –> INR –> 1 bread = 1 INR

Country B –> USD –> 1 bread = 1.5 INR

Now exchange rate of both currencies said to be 1 USD = 1.5 INR (just assume in this story)

Inflation in country always demands imports and in turn exchange rate of the currency falls against the country which they are importing.

Even few analyst predict exchange rate of the country by using inflation data. For example, if the exchange rate for US$ is Rs.67 and inflation is 4% in US and 7% in India, the exchange rate should increase (or US$ should appreciate) by 3% assuming other things remain constant.

If inflation increases then import will get increase and in turn makes currency weaker in FX markets. Now you can understand why exchange rate increases if inflation exists.

Some people have a habit of comparing the exchange rate of a particular hard currency such as US$ across the countries and make comments on the comparative value of the domestic currency. However, there is no justifiable economic reasoning for direct comparisons of the levels of the values or exchange rates of the currencies. For example, if the exchange rate of US$ is 67 Indian Rupees, 120 Yens, 1.50 Euros and 6.4 Chinese Yuan, there is no economic theory to say that Japanese is the lowest valued currency or Euro is the most valued currency or Japanese Yen is weaker than Chinese Yuan or Indian Rupee is more valued than Yen for international transactions. These exchange rates are in different values due to differences in underlying factors that determine demand and supply conditions and there are no economic techniques to quantify how these differences determine different exchange rates.

Most of the central banks of the country manipulates it exchange rate to remain competitive in the world market. For example, China devaluates its own currency in the FX market to remain competitive in the export market. We can discuss about this later.

Now we can move into next micro economic factor called Interest rate of the country.

To understand interest rate, let me give an example

Bank A gives – 2%

Bank B gives – 2.5%

From the above you can easily say if we deposit money in Bank B we can get good returns. Same is applicable for country as well. If country interest rate is high then international investors will deposit their money in that country banks or buy bonds (I am not talking about bond market in detail here). If international investors investing in that country means they have to sell their currency and buy the currency of investing country.

For example, India interest rate is 6.75% and US interest rate is 0.5%. Now US investor is looking to invest in Indian market because of better returns and investor has to sell USD in Forex market and buy INR for his investment.

Because of this, INR demand will get increased and it will get appreciated against USD. Interest rate is also one of the factor for creating demand  of that currency in international market.

As of now we saw the basic factors affecting the exchange rate of the country.

Who manages exchange rate of the country?

Even though market demand and supply decides the exchange rate of the country but the exchange rate is controlled by central bank of the country. In today’s world most of the central bank controlling the exchange rate either by selling the own currencies or buying their own currencies in FX market to control the exchange rate of the country. Central bank will interrupt in FX market based on the demand-supply micro economics.

To understand more, first we have to understand how exchange rate system works.

Up to 1973 only we had international monetary system, i.e.) collapse of Bretton woods system.

What is Bretton Woods system?

All the currencies of the world should be tied to gold and central bank of the country will be authorized party of printing currency (objective is to have fixed exchange rate system to avoid another world war). But at the end of World War II there was no enough gold in many countries, hence it was difficult to print currency against gold then US came out with different idea because they had huge amount of gold after the World War II (read the history of World War II to know how they got huge gold). US mentioned I will link US dollar to gold at the rate of $35 per ounce of gold and other countries can print their currency using USD as reserve money instead of gold (US valued their currency equals to gold). Most of the countries agreed and few opposed but somehow this system was implemented.

Brentwoods

After 1971, world’s exchange rate system shortly is classified into below

  1. Fixed exchange rate system
  2. Floating exchange rate system
  3. Managed floating exchange rate system.

Fixed exchange rate system:

In fixed exchange rate system, central bank of the country fixes the exchange rate of the country against foreign currency. There are many currencies in the world that follows exchange rate regime and even developed countries like Hong Kong also follows it. But to maintain fixed exchange rate, central bank of the country needs to maintain huge foreign reserves else fixed exchange rate is not possible.

Main benefit of fixed exchange rate system is to encourage export and to encourage international investors (avoiding exchange rate risk). But maintaining fixed exchange rate there is huge risk involved for the country because it may leads to overvalued currency, inflation and black market for FX transaction.

To understand this, let me give an example.

Country A maintain fixed exchange rate of 1.2 times of USD. Let us assume Country A is Bahamas (just for our example alone actually rate is 1 USD = 1 BSD).

What it means?

1 USD = 1.2 BSD

USD is stronger than BSD hence exports to US will provide more income to Bahamas country citizen. Because of high income there will be more export to US from Bahamas. Because of more export there will be increase in foreign reserve in Central bank of Bahamas.

Let us assume interest rate of Bahamas is 2% and in US is 0.5%. Then Bahamas will look like as better investment destination for US investors because interest rate is high and also investors are protected from exchange rate risk.

Because of high exports and international investors in Bahamas there will be huge foreign reserve currency in Bahamas Central bank.

How central bank manages exchange rate in FX market?

Central bank of the country will sell his own currency against foreign currency or buy his own currency against foreign currency depends on the market condition.

To understand how central bank intervenes in FX market I would like to go back to bread example.

Let us assume person A contains 100,000 breads, person B and person C contains 100 breads. Now all three wants to sell bread in open market and everyone in business wants to sell their goods for more profit and wants to buy at cheaper rate. Hence person B quoted sell as 1.2 $, person C quoted sell as 1.3$ and person A quoted sell as 1.1$. Now everyone who likes to buy will buy at 1.1$ because that is best buy rate (cheapest one). Rest of them (B and C) either reduce the price in open market or there breads will not make a business in open market.

Now replace the person A as Central bank of the country and the rest as market participants then you can easily visualize the economy of country. By this logic only most of the central banks devaluates its own currency in FX market especially China. This is called devaluation of currency.

If there is more export or tourism on the country then there will be huge foreign currencies on central bank of the country because international payment will occur mostly in USD then citizen of the country will exchange its foreign currency to local currency in central bank of the country. Then it will be easier for central bank to maintain low exchange rates to remain competitive in the international trade.

For export nations like China, exchange rate defines how competitive in international trade and because of this reason they devaluates its own currency in FX market to remain cheapest export country.

Disadvantages of Fixed Exchange rate:

We saw that huge foreign reserves are important for maintaining fixed exchange rate but in addition there are huge risks as well like inflation, foreign investors pulling out from the country. Before 1997, most of the Asian countries follows fixed exchange regime and this crisis made lot of changes in ASIAN economy. For example, Thailand currency crisis is one of the best example of Fixed exchange rate and they adopted floating exchange rate because of this crisis.

Fixed exchange rate increases inflation and increases money supply in economy. To understand this let me give an example and we need to go back to bread example again.

Let us assume there are 100 breads, 100 BSD in economy (equal money supply 1:1) and bread cost is 1 BSD. Because of the high production there are 200 breads produced in economy instead of deflation in country they decided to export breads to other country (assume Bahamas exports breads to US). Now Bahamas decided to export extra 100 breads to US at 1USD (100 USD = 120 BSD) and now central bank of the country needs to print additional 120 BSD and economy grows up to 220 BSD. Now inflation in country will happen because of the additional money available in economy and we already saw if there is inflation people will import more goods from foreign country. If there is more import then there is more demand on foreign currency and it makes foreign currency stronger and local currency weaker which is not the desired one for fixed exchange system.

More export –> Increase in money supply –> More imports –> Inflation –> weaker domestic currency in FX market –> Central banks steps in and buy its own currency and sells it foreign currency to maintain exchange rate.

Above is possible only if central bank has adequate foreign currencies and if not it will lead to deficit in central bank account.

To control inflation, central bank of the country needs to increase interest rate in the country. Most of the countries in today’s world uses interest rate to control inflation. But we already saw if there is more interest rate then there will be demand for local currency in FX market which leads to currency stronger. In fixed exchange rate regime, central bank loses its control in managing inflation. Inflation is one of the serious issue in fixed exchange rate system.

More export –> Increase in money supply –> More imports –> Inflation –> Increase in increase rate to control inflation –> demand increases for local currency –> Central bank steps in to sell own currency for foreign currency.

Floating and managed floating rate system:

Most of the countries in today’s world follows this system either managed floating or floating. Instead of central bank fixes the exchange rate, market demand/supply determines the exchange rate. In both the cases, central bank of the country intervenes the FX market if the exchange rate moves beyond the desired rate. India is one of the best example for floating/managing exchange rate system.

By following floating/managed floating rate system, central bank is having full control to manage inflation using interest rate. Even China Central bank says they are also following managed floating rate system but more or less they follows fixed exchange rate system.

If you look at China they are the world biggest exporting nation and if they are biggest exporting nation then there should be more demand on Yuan rite. Why Yuan is less compared to US dollar even they are biggest exporting nation? China keep on selling US dollars in FX market against Yuan so that they can maintain Yuan as lower value in FX market so that China can remain competitive in export market. Now you can understand why China keep on buying US debts!!

China foreign reserves alone equals to 3 trillion USD.

How china able to get huge foreign reserves?

Only with few countries alone China accepting Yuan as settlement and the rest of international payments for them is happening using USD. These USD are getting accumulated in China Central bank (PBOC) as foreign reserve and they need to increase the values of these reserves by buying US bonds and equities. Because of the huge foreign reserves China is able to devaluate its own currency easily.

Why India is not able to do it like China?

If you see INR in FX market it is getting weaker and weaker every year because India’s central bank (RBI) don’t have huge foreign reserve like China. India’s foreign reserve is almost around 350 billion USD which ten times lesser than China. However still RBI intervenes in FX market to control exchange rate.

When India’s INR will gets stronger against USD?

One thing we have to keep in mind, exchange rate defines how countries goods are competitive in international market. Once India becomes export nation like China then INR will becomes stronger USD like China. India reserves are ten times lesser than China and this is the right time for India to become export nation because of the low crude oil prices and programs like “Make In India”.

To say in one word we can say, look at the currency as like as other commodities. If there is more demand on currency in FX market then it will get stronger and if there is less demand then it will become weaker.

This marks end of my post, hope all the bloggers able to understand my views on FX market. IF any queries you can post in comments section. Happy new year to everyone !!

This entry was posted in Economics and tagged , . Bookmark the permalink.

6 Responses to How currency exchange (FX) rate works?

  1. Sreekanth says:

    Good explanation. Thanks.

    Liked by 1 person

  2. Subha M says:

    Good explanation with simple examples 🙂 thanks for sharing

    Liked by 1 person

  3. Sasi says:

    Nice article Shankar

    Liked by 1 person

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