What determines the strength of a currency?
November 15, 2011
Q: What factors determine the strength of a currency?
A: Currency trading is complicated by the fact that there are so many factors involved. Not only are there a number of country-specific variables that go into determining a currency's strength, but there are also other benchmarks--other currencies, for example, as well as commodities--against which a currency's strength can be measured.
However, three crucial factors are as follows:
- Interest rates. High interest rates help promote a strong currency, because foreign investors can get a higher return by investing in that country. However, the level of interest rates is relative. You've probably noticed that interest rates on CDs, savings accounts and money market accounts are very low right now. So are U.S. Treasury bond rates and the U.S. federal funds rate. Ordinarily, this would weaken the U.S. dollar, except for the fact that interest rates behind other major world currencies are also low.
- Economic policies. Tight fiscal discipline and anti-inflationary monetary policies help promote a strong currency. Again, this is all relative--the U.S.has its fiscal problems, but so do many other nations around the world.
- Stability. A strong government with a well-established rule of law and a history of constructive economic policies are the type of things that attract investment and thus promote a strong currency. In the case of the U.S. dollar, its strength is further augmented by the fact that commodities are generally traded in dollars, and many countries use the dollar as a reserve currency.
Speaking of stability, that is probably what governments seek for their currencies, more so than strength. A strong currency makes a country's exports more expensive, hurting that nation's trade competitiveness. On the other hand, a weak currency makes imports more expensive, boosting domestic inflation. So the ideal course is to aim down the middle and avoid destabilizing fluctuations.
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