What determines the value of a currency?

by | Nov 24, 2020 | Cryptocurrencies, Traditional Currency, Uncategorised

Most people only care about the value of their home currency when they are about to go on a cross-border vacation. However, the importance of a currency’s strength extends way beyond holiday buying power. All citizens benefit if their currency is respected on the global stage because it maintains the value of their savings and buying power. For those with investment portfolios, currency fluctuations can have a big impact, especially if they are invested in offshore funds, and/or interest and bond products. Chris Scanlon, CEO of Club Swan, a payment and concierge platform offering multiple currencies, says “How a currency performs against its peers, provides a window through which its country’s economic health can be viewed. It acts as a litmus test for the effective functioning of government policies, productivity, and a country’s economy as a whole.”. Many factors make up the strength of a currency and while the fundamentals are key considerations, sentiment can be an enemy of even the strongest actor.

Politics

Politics and issues management play a significant role in relative currency values. Countries that have stable leadership, a constructive opposition party, robust legal and fiscal governance, and strong economic policy, attract the attention and confidence of foreign investors. Countries with unstable governments, dictatorial leadership and poor management of state funds, tend to repel long-term investors and attract speculators. 2020 has seen an unprecedented level of political upheaval across many nations, Hong Kong, USA, Sweden, UK, India, Serbia, Belarus, Philippines, Beirut, France, Spain and many more countries have seen uprisings in recent months. These events have had a direct impact on the value of their currencies.

Another example of how politics play out in currencies is Britain’s exit from the European Union known as Brexit. The referendum, and the subsequent decision to leave the EU, has caused the currency to slump to record lows against both the Euro and the USD, as they hash out a deal for international trade. Since Britain’s decision to leave the EU on 23rd June 2016, the pound dropped a massive 8.1% in value against the Euro by 1st July 2016 As the Brexit saga continues, we could see further volatility in what was once considered a stable currency.

The Covid-19 pandemic has added to the pound’s woes. In early June 2020 it tumbled to its lowest level against the dollar since 1985, falling by almost 5% in one day when a stimulus package presented by the government failed to mitigate the economic impact of the virus.

Scanlon says “Sentiment is a strong driver of currency volatility, this means that even if a country is viewed as stable, their currency may still be affected by events that change investors’ perceptions. For example, a controversial presidential election, a natural or environmental disaster, a stock market dip, or a riot, can determine the short-term direction of a currency”.

Catastrophic Events

There is no doubt that the Covid-19 pandemic owns the centre stage of global catastrophes in the 20th century. No nation has escaped its impact, and the USD has been particularly hard hit. Coupled with one of the most divisive presidential elections in the History of the US, the impact of Covid -19 on the dollar has been severe. Despite the fact that that the USD holds court as the top reserve currency, the pandemic has precipitated some sharp fluctuations. In the early stages of the pandemic, investors predictably sought the safety of the dollar, causing it to climb 9% percent in just ten days. This move was not dissimilar to the rally during the 2008 credit crunch debacle, which saw major financial institutions fall from grace due to questionable lending practices. The dollar strengthened by 22% in mid-July 2008 as businesses held onto dollars, but by the end of the year it fell by 20% thanks to debt fears. Similarly, as the pandemic rips though the US, revealing mismanagement and negligence of the effects of the virus, the dollar has recorded its worst monthly performance in 10 years, falling 5% in July alone. The last 6 months have seen the dollar see-saw as the country tries to get to grips the unenviable reputation as the country with the highest infection rate in the world which currently standing at 12.3 million people.

Interest Rates

Interest rates play a significant role in the value of a currency. If a country has high interest rates, it may not be good for citizens that have high exposure to debt, but it would attract the interest of investors. As soon as money markets sense that interest rates might go up in a particular country, investors will invest in that currency. The South African rand is a good example of how a currency can be buoyed by speculators and investors. South Africa is among the world’s most corrupt countries, in 2019 they scored 44 on the Corruption Perceptions Index compiled by Transparency International. The Index uses a scale of 0 to 100, where 0 is highly corrupt and 100 is the least corrupt.

The current exchange rate of the Rand (as at 23-11-2020) is ZAR 15.3539 to 1 USD. While at first glance, the currency appears weak, and indeed it is, given that it was once on a par with the dollar in 1982, the fundamentals of this currency should see it trading at a much lower rate. The high yields that South African interest rates deliver, keeps investors interested. From the 3rd Jan 2011, declined from ZAR 6.59648 to 15.3539. which is around a 150% fall in value over 10 years.

Inflation

In simple terms, if a country has high inflation compared to others, it will reduce the value of their currency because the products they produce will increase in price quicker than their competitors. This would precipitate a fall in demand and a reduction of exports resulting in a decreasing demand for the currency. Conversely, if a currency depreciates, it could cause inflation to increase, as import prices would increase. An appreciation in the exchange rate tends to reduce inflation.

When talking about the effect of inflation on currency values, Venezuela is an extreme example. The statistics are jaw dropping, currently, the exchange rate is VEF 9.98750 to 1 USD, and the inflation rate is 1813.1%. Interest rates are 38.76% with deposit rates at 24%. Despite the highly attractive deposit rate, the economy and its concomitant inflation figures are too risky even for the bravest of investors, notwithstanding that inflation would wipe out any potential gains from deposits.

A current snapshot of the Majors

Major Fiat Currencies

China CNY

Shortly after the pandemic broke, global trade with china slowed to a trickle. China’s economy seems to be back on track now that that exports have resumed. Imports increased by 13.2% in September, after a fall of 2.1% in August. Exports in September rose 9.9% compared to a year ago. Strong trade performance, and increased factory activity suggests Chinese exporters are recovering, however the currency is still trading low against the Dollar and Euro. As at 23-11-2020 the current price is 1 EUR to CNY 7.8157
and 1 USD to CNY 6.5702.

Japan JPY

The Japanese Yen remains an enigma; over the years it has fended off several potential challenges to its stability. The Hong Kong protests, the bickering between the US and China, the election of Yoshihide Suga as the country’s new prime minister, and of course Covid. All these factors could have impacted the currency’s value, yet it remains stable. The Japanese Yen is the third most traded currency in the world after the US Dollar and the Euro. Japan has a large established economy and has been a top creditor nation for nearly three decades, with a national debt only second to Venezuela. Their practice of heavily buying bonds issued by other governments, protects them and when markets are hit by volatility. These bonds are offloaded and converted back into Yen, in-turn, creating demand for the currency as it gets put back into the economy. While considered a safe-haven currency, it has not escaped the sharp price fluctuations driven by Covid-19 and it is currently trading at 1 EUR to JPY 123.09 and 1 USD to KPY 104.274.

United States of America USD

To counter the effects of a slowing GDP due to Covid, the US Fed lowered interest rates to 0.25% in March to encourage people to borrow, which would have in theory, stimulated the economy. Predictably, this had a negative effect on the dollar as investors moved to alternative assets such as gold and even cryptocurrencies looking for returns. The mud-slinging contenders in the upcoming presidential election has been no friend of the dollar, and regardless who wins, both Biden and Trump will bring with them a significant amount of uncertainty. The dollar will stay in flux for some time as investors get a fix on the economy going forward. The USD’s wide and erratic movement against the Euro and other currencies since March is reflective of the current turmoil. It is currently trading at 1 USD to EUR 0.8454.

European Union EUR

The euro has not escaped the impact of Covid-19. Experts say that the Eurozone area may be impacted more by Covid than any other event in the past 20 years. In June, the IMF forecasted that growth may shrink by 10.2% this year. In layman’s terms, this means that average income will fall by 10.2% in countries that use the currency. By contrast, the Eurozone saw a 5.5% contraction during the crash of 2008. On 9 October 2020, the European Council set out a Recovery and Resilience Facility (RRF), to provide member states, with financial aid to increase public investment and reforms to counter the effect of the pandemic. The €672.5 billion facility follows the Next Generation EU (NGEU) plan of €750 billion, agreed by EU leaders in July 2020. It is anticipated that the RRF will assist member states to mitigate the economic and social impact of the pandemic, while supporting their bid to maintain the green and digital transitions needed to become more sustainable and resilient.

United Kingdom GBP

The pound has been through massive upheaval since Brexit, and now Covid-19 has dealt another severe blow to the currency. The current Prime Minister, Boris Johnson is under relentless attack from opposition party leaders, and members of parliament representing the various constituencies of the country. The law firm Baker McKenzie recently released a report that stated the combination of the fallout from the pandemic and failure to secure a post-Brexit trade deal with the European Union, could cost the United Kingdom around $174 billion each year in lost GDP, for a decade. It is not surprising that the currency has been battered. The GBP is trading at 1 GBP to 1.3319 USD and 1 GBP to EUR 1.1256.

Bitcoin

Yes, even cryptocurrencies have weighed into the financial fracas caused by the pandemic. Long touted as a possible safe-haven currency, it appears that the crypto warriors may be onto something. Scanlon says “While Bitcoin remains a long way off its record high of $20,000 in late 2017, it seems to have moved into the space of a safe-haven asset, with some supporters describing it as “digital gold”. The cryptocurrency’s limited supply of 21 million bitcoins and lack of ties to traditional financial institutions, has helped to create the support for its parallels with gold”. In the early months of the pandemic, the currency’s performance was rather lack luster, however since early March, the price has rocked from $5225.56 to $18,270 to November 23rd. It is still too early to take the crown from gold as the safe-haven asset of choice due to wide margins of volatility, but it is certainly worth keeping an eye on in the future.

“No single factor determines the value of a currency, it is an imperfect storm of economics, political stability and not so tangible perceptions. These times are unprecedented, and they are playing out in every currency across the world” concludes Scanlon.

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