As I write this, the Philippine peso has fallen to P54.25 against the US dollar. What’s driving the lower exchange rate?
Pesos, dollars, euros, and yen swing about with all the purpose and excitement of a toddler in a toy store. Yet there is a method to their madness.
In the long term, the most important driver of the exchange rate is inflation. A country that persistently runs higher inflation than its trading partners will see its currency fall as its purchasing power declines. As far as I can remember, Philippine inflation has always been higher than the US’, and so, it should be no surprise that the peso declines against the dollar. In the 1970s and 1980s, Britain’s inflation was higher than Germany’s, and so the British pound declined against the deutsche mark, the currency Germany used until it adopted the euro in 2002.
Now, suppose Britain and Germany both export similar cars, but their prices rise five percent a year in Britain because of higher inflation and just two percent in Germany. Customers will buy fewer British and more German cars. Demand will decline for the British pound and rise for the deutsche mark. Eventually, the pound will fall enough to make British cars as cheap as German cars again.
A related driver of currencies is productivity. Suppose Filipino workers and managers find a way to make more “widgets” with the same number of workers. They would soon be able to sell them more cheaply than their foreign competitors. Filipino exporters’ sales would rise, earning them more dollars, euros, yen, and whatever. As they exchange those currencies for pesos to pay their workers and shareholders, the peso would rise. Eventually, its increase would cancel out the cost advantages those exporters had achieved through higher productivity.
These examples show that between two countries, the one with the higher productivity growth and lower inflation should have the stronger currency.
Another related driver of currencies is savings. As of June 2018, the Philippines recorded a current account deficit of $824 million. This means that the country paid foreigners more for imports, interest, and dividends than it received from them. To finance such as deficit, a country has to either borrow or sell some assets, such as stocks, bonds, companies, buildings, or land to foreigners, with the result that the country’s foreign debt mounts. There’s nothing wrong with a current account deficit. Just as a start-up company needs outside investors to develop its technology, a country often lacks the savings to exploit its investment opportunities. Foreigners lend it money or purchase shares in its companies so it can build roads, bridges, railroads, subways, or erect factories. The investments make the country wealthier, generating wages and profits to repay the foreign investor. If a country’s assets are in big demand, its currency will remain strong, preventing the current account deficit from correcting itself. If its assets are not in big demand, its currency will fall.
While inflation, productivity, and savings behavior determine a currency’s behavior in the long term, lots of things push it around in the short term.
First are interest rates. Countries with higher interest rates attract foreign investors who buy its bonds hoping to earn those higher rates, creating demand for the currency. Lower rates do the opposite. This doesn’t work though if interest rates are higher only because of inflation. It’s the real interest rate (the nominal interest rate minus inflation) that matters.
Second are economic prospects. When a country’s economic outlook improves, its investment opportunities look more attractive and its central bank raises interest rates to stave off inflation. Both those things attract foreign investors, bolstering the currency.
And third is greed and fear. Currencies are a real time indicator of how the world feels about a country, and those feelings can change quite suddenly, from overconfidence to panic. When the country or the world looks like a more dangerous place, because of a president’s behavior, war, or financial meltdown, the political and economic stability of countries such as the US and Switzerland are particularly appealing and their currencies become safe havens. A country with a rock-solid currency can see it plummet if foreign investors suddenly lose confidence in it.
There are a lot of great theories behind currency movements, but economists who study them have found that in the short term, the average person, economist, and political leader are better off flipping coins. People persist in trying, though: The foreign exchange market is the biggest and deepest on the planet and the only one that truly trades around the clock.
The bottom line: In the long term, inflation, productivity, and savings are the main drivers of a currency. In the short term, interest rates, economic growth, and greed and fear dominate. A stable monetary policy is essential for the control of inflation, efficient allocation of investment, and achievement of economic stability.
