Any news and information regarding the country’s economy can have a direct impact on the direction the country’s currency is heading towards; just as how the current events and financial news affect the stock prices.
Several factors prove helpful in building long-term strength or weakness of the major currencies and will have a direct impact on you as a forex trader.
Economic Growth and Outlook
Countries with strong economic growth will surely attract foreign investors and thereby strong currency value. If the economic growth and outlook is positive, it indicates there is low unemployment rate, which in turn means higher wages to the people. Higher wages means people have more spending power, which in turn indicates higher consumption of goods and services. Thereby, this propels the economic growth of the country and there is an increase in the currency prices.
Inversely, if the economic growth and outlook of a country is weak, it indicates the unemployment rate is high. This shows that the consumers do not have the spending power; there are not too many business setups. The government (central bank) is the only entity that is spending. This leads to a decrease in the currency price.
Therefore, the positive and negative economic outlook will have direct impact on the currency markets.
All thanks to globalization and technological advances which have kind of provided wings to the market participant to invest or spend virtually anywhere in the world.
Capital flows means the amount of capital or money flowing in or out of a country or economy because of capital investment via purchasing or selling.
We can check how many foreign investors have invested in our country by looking at the capital flow balance, which can be positive or negative.
When a country has positive capital flow balance, it indicates more people have invested in the country than investments heading out of the country. While a negative capital flow balance indicates investments leaving the country is much more than investment coming in.
A higher capital flow means more foreign buyers have invested, which in turn increases the currency prices (as investors want to buy your currency and sell their own).
Consider an example of USDINR currency pair – if on one particular month, capital flow is very large, directly it indicates that more foreign buyers are keen on investing in our home country. For this, they need local currency. Therefore, the demand of INR will increase and the supply of foreign currency (USD or Euro) will increase. The decrease in the price of USDINR depends on what the overall capital balance is.
In simple terms, if the supply is high (sellers are more) for a currency (or demand is weak), the currency tends to lose value (buyer are less).
Foreign investor are happy to invest in a country with −
- high interest rates
- strong economic growth
- an up trending financial market
Trade Flows and Trade Balance
The Export and Import of goods from one country to another is a continuous process. There are exporting countries, which sell their own goods to other countries (importing countries) that are keen on buying the goods. Simultaneously, the exporting country becomes an importing country when it in turn buys something from another country.
The buying and selling of goods is accompanied by the exchange of currencies, which in turn changes the flow of currency, depending on how much we export (value) and import (value).
The trade balance is a measure to calculate the ratio of exports to imports for a given economy.
- If the export bills of a country are higher than our import bills, we have trade surplus and the trade balance is positive.
- export bills > import bills = Trade surplus = positive (+) trade balance
- If the import bills of a country are higher than our export bills, we have trade deficit situation, and the trade balance is negative.
- import bills > export bills = Trade deficit = negative (-) trade balance
Positive trade balance (trade surplus) comes with the prospects of pushing the currency price up compared to other currencies.
The currencies of the countries with trade surplus are more in demand and tend to be valued higher than those in less demand (trade deficit countries’ currencies).
The socio political environment of a country
Foreign investors prefer to invest in countries where the government is stable, having stable laws for business. Instability in the current government or major changes in the current administration can have direct impact on the business environment, which in turn can have an impact on the country’s economy. Any impact to an economy positive or negative will directly affect the exchange rates.