There is no greater turmoil in the “Seely household” than when it comes to converting funds and trying to determine the movement of a foreign currency exchange rate. Research is done, historical charts are reviewed, articles are read, close monitoring is done on the “spot rate”; hoping, wishing … and even praying that when the conversion occurs, you snap up the best rate possible.

I don’t know about you, but I never seem to get the best rate; no matter how much research I do or what website or banking institution I use, I always seem to miss the target slightly.

First, and most importantly, I am not a foreign exchange trader, but I am a believer in diversification, and seeking investment opportunities outside of the world’s reserve currency, the US dollar, is a key component of my long-term financial planning.

So, what are some of the factors that influence foreign exchange rate movements?

Interest rates

A significant driver of exchange rate movements is the level of interest rates set by a country’s central bank. Higher interest rates provide higher returns on investments denominated in that currency, and this attracts foreign capital and increases demand for that currency. Conversely, lower interest rates can lead to lower capital flows, as investors seek better returns elsewhere.

Economic indicators

Economic indicators, such as GDP growth rates, unemployment rates and consumer spending, also play a significant role in influencing exchange rates. A country’s economic performance directly affects investor confidence and can lead to currency appreciation or depreciation.

Political stability and economic performance

Political stability and overall economic performance are critical factors for determining a currency’s exchange rate. Countries perceived as politically stable and economically sound attract foreign investors, which leads to increased demand for their currency. On the other hand, political unrest, corruption or major changes in governance can create uncertainty, causing a decline in currency value.

Speculation and market sentiment

Speculation and market sentiment can greatly affect exchange rates. Traders and investors often buy and sell currencies based on their expectations of how events, economic data or geopolitical developments will influence future exchange rates. If traders believe a currency will strengthen due to upcoming economic data, they will likely buy that currency in anticipation, and this can lead to an appreciation of its value.

It is critically important to be aware of what influences exchange rates, especially since we have such an interconnected global economy, and to understand how market sentiment – along with interest rates, inflation rates and political instability – can result in significant fluctuations in currency values.

On the other side of the coin, if your currency is “pegged” (i.e., fixed) to another currency, like the Bermuda dollar or the Belize dollar are to the US dollar, it is important to know what the pros and cons are to such an arrangement.

A 2024 article written by Privalgo explained the main reason why countries peg their currency is to eliminate exchange rate volatility (i.e., preventing any sudden or significant shifts in value), and that by doing so, they can ensure that foreign businesses and investors will be more confident about the price they will pay for the country’s currency going forward, thus facilitating more trade and investment.

However, the article also explained there is a significant downside to pegging currencies, noting that countries that do so ultimately lose control over their monetary policy, since they must prioritise maintaining the peg over other economic objectives, which if done poorly can deplete the country’s foreign reserves and lead it into a deficit position.

Benefits of a “pegged” currency

• Stability

One of the primary advantages of a pegged exchange rate is stability. Linking a currency to a stable reference value mitigates inflation and reduces exchange rate volatility, fostering a predictable environment for international trade and investment.

• Inflation control

Pegged exchange rates can help countries with a history of high inflation gain monetary policy credibility. By anchoring their currency to a stable currency, they can avoid the pitfalls of hyperinflation and build investor confidence.

• Encouragement of foreign investment

A predictable exchange rate can attract foreign investors. When investors know that a country’s currency will not fluctuate wildly, they are more likely to invest in its assets, and this can stimulate economic growth.

Downsides of a “pegged” currency

• Loss of monetary policy control

One significant drawback of a pegged exchange rate system is the loss of independent monetary policy. Countries must adopt strict policies to maintain the peg, and as mentioned earlier, they often have to sacrifice domestic economic growth for the sake of exchange rate stability.

• Trade imbalances

Maintaining a fixed exchange rate can lead to trade imbalances, since the currency may become overvalued or undervalued over time, which can harm domestic industries and lead to economic distortions.

What would cause a currency peg to break?

One of the primary reasons why a currency peg might break is political instability. Buckley (2023) explained in his article what aspects of political instability can drive a pegged currency to break:

• Political turmoil within the governing party (eg, resignations, corruption scandals)

• Poor economic policies

• Significant government overspending

• Racial disparity-driven governance

What are the effects?

When a country abandons its currency peg, the impact is initially jolting, with most countries experiencing some degree of economic disruption, including an economic slowdown, especially if that country is not a producer of goods.

Economists also argue that there can be a sudden and large drop in the value of the currency, which can cause inflationary pressures and a rise in unemployment.

How long it takes the country to stabilise its currency again will usually depend on the soundness of economic policies and the stability of the government going forward.

At the end of the day, when you are moving money from point A to point B and you are wondering what is driving it to move in one direction or the other, it is important to realise that it is our government and their decision-making that influence the direction.

References

Buckley, D. (2023) What Causes a Currency Peg to Break? Available from: https://www.daytrading.com/currency-peg-break [Accessed 2 November 2024].

Privalgo (2024) What is a pegged exchange rate and why do countries do it? Available from: https://www.privalgo.co.uk/what-is-a-pegged-exchange-rate/#:~:text=Loss%20of%20monetary%20policy%20control, peg%20requires%20significant%20foreign%20reserves. [Accessed 4 November 2024].

• Carla Seely has 24 years of experience in the financial services, wealth management and insurance industries. Over the course of her career, she has obtained several investment licences through the Canadian Securities Institute. She holds ACSI certification through the Chartered Institute for Securities and Investments, UK; QAFP through FP Canada; and AINS through the Institutes. She also has a Master’s degree in business and management