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Eureka: How do exchange rates fluctuate? Eureka: How do exchange rates fluctuate?
by Akli Hadid
2017-09-01 08:22:48
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In any country, a majority of the population is not involved in exchange rates or foreign currency. Most national transactions are done in local currency. Those involved in foreign currency include businesses who trade outside the country and who have to sell in foreign currency which is converted to local currency, those who travel abroad and need foreign currency or those such as the government who speculate on foreign currency and buy foreign currency as a safety net in case local currency fluctuates too much. Government-owned companies who export and earn foreign currency are in the mix as well, and some of them are very large companies, such as in oil-producing countries.

flat1Now why do exchange rates fluctuate? Let's take three examples. First lets say company A sells shoes around the world. Company A has a factory, let's say in Mexico. Let's say they manufacture everything from sandals to street shoes to sports shoes to wingtips to women's shoes. Let's say the export shoes to other Latin American countries and that payments are made in US dollars. Let's say, for example purposes, that they make 1 million dollars a year in profits.

Company A then decides to borrow money to expand production and to purchase machines and technology that will help them make better quality shoes, both so they can become a household brand and they can export to the rest of the world. Image that companies B, C, D, E, F etc. in Mexico also borrow money with the same drive. However, those companies fail to compete with the big names, sales aren't what they promised to be. Let's say they needed to cash in 5 million dollars to break even and repay their loan. Let's say their loan was in Mexican pesos. Eventually they would need to devaluate the peso so that their sales in dollars can better help them repay their loan in pesos. So devaluating the peso would help repay the loan faster.

Now let's say government A makes a huge loan to improve infrastructure around the country. Borrowing in foreign currency would help build the kind of infrastructure that would increase the domestic output and economic growth. Things don't go as planned the government owes millions or billions of dollars to foreign banks. The government then devalues its currency so that it can the inflation can help collect more local currency to repay the loan.

On the other hand, there are speculators who buy foreign currency becacuse their local currency tends to fluctuate so they buy foreign currencies that tend not to fluctuate so much. So obviously devaluating the local currency would help governments buy the much needed foreign currency from speculators at a much higher rate, that being their only choice to earn foreign currency. This is also why in some countries tourists can pay ridiculously low prices in foreign currency to help government earn the much needed foreign currency.

Now let's take the opposite side of the story. There are countries who over-value their local currency. Banks in such countries systematically deny loans and force locals to save parts of their earnings, only injecting parts of the local currency back to the market. This means they can get favorable exchange rates which helps them buy foreign currency at technically undervalued rates, meaning they can stock up on foreign currency. In such markets there are black markets for loans, and unlike banks, they can be pretty ruthless if the loans are not paid back.

So there are mainly three pressure groups when it comes to foreign currency evaluation: governments, businesses and households. If the government debt is high, the others get punished with devaluation. If businesses go on a loan spree, the rest get punished with devaluation. If households go on a borrowing spree, you get devalation.

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