Forex market trades more than USD 5.3 trillion each day and is known as the largest financial market in the world. Currency trading works in the same manner as the stocks does; you buy shares in stock as you buy currency in Forex, for the purpose of trading and generating profit. All currency trading is done in pairs. A trader buys an amount of currency against another to make profit from the discrepancy of rates in the two currencies emerging out of fluctuation in rates. Since there’s involvement of a pair, the effect of both country’ economy on forex rates and vice versa are inevitable.
Multiple factors come into play for Forex to affect an economy. It’s important to have a close look at FX trading from various angles to understand what factors in Forex influence the economy of a country.
Retail FX Market.
Forex is split into two major sectors of institutional and retail trading. Retail trading hardly has any impact on the economy as its volume, compared to that of institutional, is very low. To get a better understanding of retail trading, one can have a look at how babypips and keystock work.
Institutional trading is mostly done by financial giants and is often transnational. Therefore, its volume is relatively bigger than any other form of trading. Institutional trading does not have a direct impact on the economy; rather a country’s economy is more dependent on the demand of its currency, per the demand supply rule. The more the currency in need, the higher the price for its set. For example, USD being the base currency for international trade, is very high in demand. Most of the Forex trade also takes place against US Dollar. The demand of this currency also somehow gives a boost to the economy as MNCs use Dollars to pay their employees, financial companies keep their accounts and banks have their reserves in US Dollars.
It’s near to impossible to impact an economy with retail or institutional trade, but it cannot be neglected that the overall circumstances of a country do influence the rates of forex and eventually the economy In an age of increasing dependability, it has a domino effect which results in fluctuation of all currency rates.
Some other aspects to it are as follows.
The basic purpose of the Forex market is to help large banks, MNCs, local industry, government and other financial institutions with their international transactions. It’s a sign of a thriving economy that it’s able to purchase a foreign currency quickly and reliably and also at a low rate. This ability also allows any state to gain huge benefits in terms of its economy. Such states in the international market are known as super powers and have a great edge over small economies. It’s easier for countries with higher foreign exchange rate to purchase goods in the international market. They enjoy all the benefits of possessing a high priced currency, so when it’s exchanged with a currency of a smaller economy, the other takes advantage.
Speculative price movements.
It’s a tendency of large markets to attract traders and speculators to it. The sign of big markets is that they have enough liquidity to suffice the needs of all traders. It has been noted that markets that fail to provide for the needs of its speculators usually fall behind others. So, speculators are very important for the sustenance of a market.
The type of bull and bear speculators also cast an impact on the Forex rates. Contrary to stock exchange crashes, a forex crash is less massive, but there is no denial that it takes place.
This situation brings a win for some and loss for others. Exporters often face a blow as the result of a decline in foreign exchange, if he receives an order quoted at a low price and delivers it when in the meanwhile price changes, it’s the exporter that faces a major loss while importers enjoy the profit.
Long Term Adjustment.
The decline or hike in a currency rate reflect the economic condition of a state. If the change in value is staying long term then the influence of it on the economy is inevitable whereas, a short-term change in value also affects speculations. It’s essential to make long term adjustments in such a case.
There are benefits that small economies enjoy; there’s an influx of tourists that like to visit a country with cheaper currency, giving rise to the tourism of that state and demand for its currency. When a tourist visits, he makes purchases of the country’s products too. It’s a chain of events that takes place. This results in the ease of payment of taxes and generating revenue, resulting in the growth of a country’s economy.
As economies grow, the products that are manufactured in those countries increase in price too. There is a direct influence of economic condition over the exports and imports of a country. Strong economies like France and Germany sell the most expensive finished goods, while weaker economies have attractive range of raw material for the buyers. This process of dependence of Periphery countries on the Core and vice versa help keep the world economy in a balanced position and minimizes the deficit.
The present condition of Eurozone is a lesson to learn for many. The large economies like France and Germany help the small ones in the form of funds needed to sustain and smaller ones like Greece and Portugal help these countries by providing them with a port and trade route. So, there is interdependence of large economies on smaller ones and of small ones on large.
So, it can be easily concluded that there are many factors that influence the forex rates and those factors also determine the growth or fall of economies.
International trade is one of the most important factors that influence the rates of forex. When states thrive in economy and achieve a high status, the products of those economies get better in quality as well. With the improvement in quality, the demand for those products and the reliability of different nations on the durability of those products increase too. This results in call for goods by international buyers also. When a country provides the best quality of product, there is an increased demand of international market for the supply of those items. This eventually results in the growth of an economy. There are treaties done by many countries in the international system that authorize any kind of trade to take place in their currency. For example, Russia and China do trade in Yuan, the Chinese local currency than choosing USD. This move has positively affected the economy of China, as the trade which used to take place in USD previously, was giving benefits to the U.S with the foreign exchange and circulation of the USD. while, the ultimate beneficiaries of the trade today remain to be the two parties involved in it.
There is another phenomenon which helps foreign exchange leave an impact on the economy. For instance, if a product is to be purchased in Australian Dollars, the international buyer would be required to change the currency from his local to Australian currency, which will increase the demand for the Australian currency, ultimately giving boost to the economy of Australia.