A screen displaying various foreign currency exchange rates is seen at a money changer in Kuala Lumpur. Image Credit: AFP

Dubai: Ever wondered why some currencies fluctuate and why do some turn more volatile than others? While some currency rates are jumping to all-time highs, others plunge to record lows. Exchange rates are constantly fluctuating, but what, exactly, causes a currency's value to rise and fall?

It is true that with 180 currencies around the globe, no country’s currency value remains static, and when pegged with other currencies, the value of money changes every moment.

However, why some currencies fluctuate more than others, is the same reason why international online shops sometimes list prices in US Dollar or Euro, or when you go on an overseas holiday, certain services are priced in a non-domestic currency – some currencies are stronger or more stable than others.

Before we know why exactly that is, and to understand why some countries witness unpredictable movements in exchange rates in the global foreign exchange market (known as currency volatility, foreign exchange or FX volatility) – let’s first see which currencies are more volatile than others.

Indian, Pakistan rupee, Philippine Peso among most volatile
Asian currencies – particularly those of India, Pakistan, Bangladesh, Sri Lanka and the Philippines – have consistently been more volatile compared to more stable currencies like the US Dollar, the European Euro, the Swiss Franc, the Japanese Yen or the British Pound Sterling.

In the last decade, the Indian Rupee (INR) has devalued against the US Dollar (USD) by about 60 per cent, implying that in these years the INR has become weak compared to USD. Countries like Kuwait, Bahrain, Oman, Jordan, which see lot of USD coming in in form of investments sees its currency getting stronger.

Analysts evaluate factors that make currencies of developing countries more volatile than their developed counterparts include, comparatively lesser influence practiced by the countries, economies not being as diversified as developed ones, and regulations being more restrictive than others.

Why developing countries’ currency fluctuates?

Currencies can be loosely categorised as ‘hard’ and ‘soft’, the former being seen as reliable, widely accepted, and a store of financial value. There is no defined list of them, but the more developed a country is, the more it’s assumed to be one that holds a ‘hard’ currency.

Developing countries have a volatile or a ‘soft’ currency. International trade also gets priced in hard currencies, over ‘soft’ currencies, which in turn adds to the steadiness of the top currencies, and to the volatility of the weaker ones. Let’s next look at why this is.

Flux stems from uneven supply and demand

Although there is no single indicator that explains exactly why a currency has fluctuated or predicts with certainty what its price will do, understanding the science of supply and demand, and other factors relating to it, will help you gain a better grasp of why this happens.

Simply put, currencies fluctuate based on supply and demand for a given currency. Most of the world's currencies are bought and sold based on flexible exchange rates, meaning their prices fluctuate based on the supply and demand in the foreign exchange market. A high demand for a currency or a shortage in its supply will cause an increase in price.

A currency's supply and demand are tied to a number of intertwined factors including the country's monetary policy, the rate of inflation, and political and economic conditions, which we will explore in detail further below.

So, why does a currency fluctuate?
Currency prices for any economy are determined by two ways – floating exchange rate and a fixed exchange rate. Floating exchange rates, or flexible exchange rates, are determined by market forces without active intervention of central governments.

The floating exchange rate is determined by the supply and demand in the forex market as practiced by most advanced economies that allow their currencies to freely float in the market. The fixed exchange rate on the other hand is predominantly determined by the governments of countries like China.

Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. A currency's exchange rate is typically determined by the strength or weakness of the underlying economy. As such, a currency's value can fluctuate from one moment to the next.

Effects of a fluctuating currency

The level of a currency relative to another has ramifications on a country’s ability to import and export. A weak currency allows it to export more through increased competitiveness, but it then results in the import of goods becoming more expensive.

Generally, a weaker currency stimulates exports and makes imports expensive. Constant currency fluctuations can also affect the market adversely, causing it to become volatile, and affecting both local and foreign trade.

For instance, due to heavy imports, the supply of the currency may go up and its value fall. In contrast, when exports increase and dollar inflows are high, the currency strengthens.

What's the perfect exchange rate to remit? Here is a checklist. Picture used for illustrative purposes. Image Credit: Gulf News Archives

Economic factors that force a currency’s value to fluctuate

• Monetary policy

Many countries’ central banks attempt to control the demand for currency by increasing or decreasing the money supply and/or benchmark interest rates. The money supply is the amount of a currency is printed and in circulation.

As a country's money supply increases and the currency becomes more available, the price of borrowing the currency goes down. The interest rate is the price at which money can be borrowed. With a low interest rate, people and businesses are more willing and able to borrow money.

As they continually spend this borrowed money, the economy grows. However, if there is too much money in the economy and the supply of goods and services does not increase accordingly, prices begin to inflate.

• Rate of inflation

Another variable that heavily influences the value of a currency is the inflation rate. The inflation rate is the rate at which the general price of goods and services are increasing. While a small amount of inflation indicates a healthy economy, too much of an increase can cause economic instability, which may ultimately lead to the currency's depreciation.

A country's inflation rate and interest rates heavily influence its economy. If the inflation rate gets too high, the central bank may counteract the problem by raising the interest rate. This encourages people to stop spending and instead save their money.

It also stimulates foreign investment and increases the amount of capital entering the marketplace, which leads to an increased demand for currency. Therefore, an increase in a country's interest rate leads to an appreciation of its currency. Similarly, a decrease in an interest rate causes depreciation of the currency.

• Political and economic conditions

The economic and political conditions of a country can also cause a currency's value to fluctuate. While investors enjoy high interest rates, they also value the predictability of an investment. This is why currencies from politically stable and economically sound countries generally have higher demand, which, in turn, leads to higher exchange rates.

Markets continually monitor the current and expected future economic conditions of countries. In addition to money supply changes, interest rates, and inflation rates, other key economic indicators include gross domestic product, unemployment rate, housing starts, and trade balance (a country's total exports less its total imports). If these indicators show a strong and growing economy, its currency will tend to appreciate as demand increases.

Similarly, strong political conditions impact currency values positively. If a country is in the midst of political unrest or global tensions, the currency becomes less attractive and demand falls. On the other hand, if a market sees the introduction of a new government that suggests stability or strong future economic growth, a currency may appreciate as people buy it based on the good news.

Why some currencies fall more than others?

Developing countries, like the ones mentioned earlier, and also Brazil, Indonesia, and Turkey, among others, have become favoured destinations for international investors over the past decade, attracting capital to their fast-growing industries and delivering a boost to the global economy.

But unlike the US, UK, Japan, and increasingly, China, developing or markets have an inherent weakness: few investors are willing to stockpile their currencies. If cracks are detected in an economy, investors will dump the local currency and extract dollars, leaving behind devalued reals, rupiahs, and liras. This dynamic has caused decline-driven crises in several regions over the past decades.

Currency crises, which many economists define as a swift decline of more than 20 per cent of a local currency against the dollar, have hit dozens of developing countries over the past three decades, and have occasionally triggered regional recessions like the Latin American debt crises in 1982 and the Asian financial crisis in 1998.

Stock Money exchange dirhams currency
Picture used for illustrative purposes.

Can currencies crash?

Currency declines typically follow a series of political, economic, and market forces that combine to pressure the exchange rate. Countries in crisis tend to run persistent current account deficits, importing more than they are exporting or borrowing capital from foreign lenders, often with short-term maturities, to finance public budget deficits and long-term projects.

Capital flows can be unsteady, and after years of inflows from foreign investors, market sentiments can suddenly shift and dollars are sucked out of a developing market, driving down exchange rates.

As currency value falls, it creates a panic that leads to mass sell-offs of currency and investments, which further induces depleting reserves in a country, raising domestic interest rates, and sometimes triggering recessions.

Why understand currency fluctuations?

Currency fluctuations have a significant impact on us. For example, buying a foreign car might get more expensive if your country's currency depreciates, which means that you might end up paying more money to get an item of the same value. On the other hand, a stable currency allows us to buy more.

When you travel overseas, one of the routines you become accustomed to is exchanging your currency for the local currency. Many people get surprised by the different amounts of local money they have once their currencies are turned in.

Clearly, fluctuating global currencies are a constant in volatile international capital markets. Consequently, there can be plenty of ways to capitalise on the wide swings of currencies.

UAE dirham viewed as the most stable
UAE dirham is viewed as among the world's most stable currencies in terms of exchange rate stability. The reason for this is the country has imposed what you call a ‘fixed’ exchange rate system, which is where the price of a currency is 'fixed' with respect to another currency.

All the GCC countries, excluding Kuwait, have their currencies pegged to the US dollar. The UAE dirham has been fixed at a rate of 3.6725 to $1 since 1997. The Kuwaiti dinar is pegged to basket of currencies, after scrapping its dollar peg in 2007.

How a declining currency benefits you?

Now that we have understood what causes currency fluctuations, we can look at how we can utilise a declining currency.

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The Pakistani rupee, for example, has historically been on a downward trend and is known to benefit overseas Pakistanis working in the UAE and other countries as they will be able to remit more money. A weaker rupee will also increase the buying power of overseas Pakistanis when it comes to investing back home.

Rupee depreciation would increase the country's competitiveness and exports from Pakistan would become cheaper. The pace at which the rupee is depreciating will have an effect on inflation levels in Pakistan.

Even from the side of a UAE-based businessman this is good news. The rupee's decline is good for UAE-based businessmen because its weakness will make imports cheaper from Pakistan.

The businessmen who let’s say import vegetables and fruits and other food items from some of the major cities in Pakistan, even after inflation adjustment, prices are almost still the same but they will be sending less dirhams now to purchase stuff from there.

Another benefit is in India, for example, where remittances are one of the significant contributors to the foreign exchange reserve and makes up nearly 25 per cent of total foreign exchange reserves in the country, the depreciation of the Indian rupee always has a positive impact on the remittances.

The country has witnessed 50 to 80 per cent growth in remittance activity from several nations, particularly the Gulf region, during the recent months. A similar trend occurred in 2012, 2013 and 2014 when the rupee witnessed a sustained depreciation.