Dubai: Have you ever wondered why central banks around the world are raising rates in tandem with the US? Does currency movement and fluctuating exchange rates have anything to do with it?
This is partly the case. One of the reasons why higher interest rates in a country can increase the value of that country’s currency compared to countries offering lower interest rates.
Economic stability and a country’s demand for goods and services are also key factors in currency valuation. Inflation often leads central banks to set higher interest rates to help cool a booming economy.
However, when it comes to exchange rates, the correlation with interest rates is not so straightforward. Let’s understand why.
Do exchange rates rise or fall when interest rates rise?
A country raising interest rates can be a major factor influencing currency value and exchange rates, but the exchange rate of a currency with other currencies is detrimental to a number of other factors. .
A number of other interrelated elements that reflect the overall financial condition of a country relative to other nations are responsible for the rise and fall of an exchange rate.
Higher interest rates increase the value of a country’s currency, primarily because higher interest rates tend to attract foreign investment, increasing the demand and value of the home country’s currency .
Conversely, lower interest rates tend to be unattractive for foreign investment and lower the value of the currency.
Do interest rates alone affect the value of a currency? No.
Interest rates alone do not determine the value of a currency. One factor that blurs the correlation between interest rates and the value of a currency is how higher interest rates follow high inflation.
This is because central banks often raise interest rates in response to rising inflation in an effort to calm an overheated economy.
However, if inflation rises too quickly, it can devalue a nation’s money faster than interest rates can compensate savers.
How Economic Stability Plays a Crucial Role in Currency Valuation
A country with a better balance between imports and exports can be a factor in determining the value of the currency, as greater demand for a country’s products also means greater demand for its currency.
Besides a trade balance, another indicator of economic stability that investors consider when evaluating a given currency is gross domestic product (GDP, i.e. the total value of goods produced and services provided in a country During a year).
A country’s debt level is also vital. High levels of debt, although manageable over shorter periods, can lead to higher rates of inflation and possibly lead to a devaluation of a country’s currency.
How a stable US dollar keeps exchange rates elsewhere under control
The US dollar records favorable exchange rates against the currencies of most other nations, as most countries hold their foreign exchange reserves in US dollars.
The US dollar is most often seen as a safe haven for currency investors, as the value of the US dollar has remained stable.
How Inflation Affects Exchange Rates
Inflation and interest rates are closely linked and both affect exchange rates. Some inflation – the rise in prices of goods and services – is healthy for an economy because it shows an increase in demand relative to supply.
However, too much inflation can be a problem as goods and services become less affordable. Central banks take this balance into account when setting interest rates.
If inflation is below its target level, a central bank may seek to cut interest rates. Lower interest rates make borrowing cheaper and saving less rewarding, encouraging people to spend.
This increase in demand can drive up inflation. But if inflation rises too fast, a central bank can raise interest rates, aiming for the opposite effect.
Higher rates can make borrowing more expensive and more rewarding to save, reducing demand and slowing inflation.
Higher interest rates can increase the value of a currency. They can attract more foreign investment, which means more money entering a country and higher demand for the currency.
Will higher interest rates affect remittances?
When the value of your local currency increases, remittances are often discouraged because you get less for your money when looking to send more money home. But this trend is not sustainable.
As explained above, the currency strengthens when the interest rate is raised and weakens when it is lowered. This is because the currency’s exchange rate is determined by investors who trade amounts of currency.
If there are signs that the economy is expanding (such as interest rate hikes), then the currency becomes more desirable, causing investors to demand more.
When investors buy more, the value of the currency increases. However, it is not just raising or lowering interest rates that has an impact on the value of the currency.
Despite rising interest rates and the currency soaring initially, in the long run your home currency is expected to weaken, which is favorable for expats when it comes to the best remittance rates.
Key points to remember
As interest rates rise, interest in that country’s currency increases. As global investors pour their money into countries, they get a higher return on their investment.
If a country raises its interest rates over a long period of time, it can cause a general trend against other currencies. Sometimes a country will have a high interest rate but a falling currency.
Such a disparity is usually an indication that the amount of interest they are paying is not worth the required risk. The other thing it may indicate is that there are signs that rates will soon be lowered.
While it’s true that rates aren’t moving much, expectations about the direction and steepness of rate changes seem to change from week to week.
There are always multiple factors that move a currency, but interest is one of the number one factors, followed only by risk.
So, in addition to rising or falling interest rates, the currency can also be affected by surrounding interest rates, economic data and expectations regarding the direction of interest rates, as well as a host of other factors.