5 minForeign exchange: Reflecting world economies
Maxime Smekens With over 6,500 billion trades a day, the foreign exchange market is the most liquid and volatile market in the world. Liquid because there are always plenty of buyers and sellers at any given time: the foreign exchange market is open 24 hours a day, 5 days a week, and is totally decentralized, i.e. there is no physical location or centralized exchange where transactions take place. Volatile, because exchange rates are influenced by a large number of factors. What's more, it's all relative, since it involves comparing the state of one economy with another via fluctuating currency pairs.
The most widely traded currency pairs, often referred to as hard currencies, include currencies such as the US dollar (USD), the euro (EUR) and the Japanese yen (JPY).
In November 20231, we highlighted the fact that certain developing-country economies were making their mark on the international scene, notably through their growing and increasingly prosperous middle classes. In line with this positive dynamic, investors are turning their attention to underlying currencies, which are likely to strengthen. Currencies such as the Chinese yuan (CNY), the Mexican peso (MXN) and the Brazilian real (BRL) have expanded the diversity of pairs available on the forex market.
A true reflection of investor sentiment the world over, the state of equilibrium of a currency on the forex market reveals precious clues to the economic health of each country, and provides clues to future trends. A close reading of this borderless market enables us to identify its risks and opportunities, and in this context, 4 factors provide a better understanding of the subject.
Macroeconomic fundamentals and geopolitical stability
Macroeconomic fundamentals, such as controlled inflation, healthy economic growth, a positive trade balance and a credible central bank, influence investor confidence in the foreign exchange market. Strong currencies from stable, developed economies offer greater liquidity and more reliable economic predictability. Emerging currencies, on the other hand, are more sensitive to economic and geopolitical changes, and have volatile characteristics. To capture investors' interest, emerging currencies need to benefit from a high interest rate environment (1) where inflation is decelerating significantly (2), in addition to stable or improving macroeconomic fundamentals (3). The first point compensates the investor for the additional risk involved. The second establishes a sense of credibility, dispelling the fears of inflationary spirals that often plague developing countries. Finally, the third point adds robustness to the investment thesis.
For example, if Mexico's GDP growth outstrips that of the US, it would be logical to see the Mexican peso appreciate against the dollar. Of course, there is never just one reason why a currency appreciates or depreciates.
Raw materials and positioning in global production chains
While strong currencies are based on complex, tertiarized economies, this is less often the case for emerging currencies. Indeed, the economic growth of certain developing countries is closely linked to their raw materials. Some countries have succeeded in integrating themselves effectively into value chains, while others are weakened by an overdependence on the export of their raw materials.
So when 80% of a country's exports are made up of a single commodity (e.g. coffee), it seems clear that a rise in the price of the commodity will, all other things being equal, be good for its currency. But we also understand how dependent the country is on this source of income, whereas the much more diversified developed economies offer a completely different kind of stability.
When one or more commodities rise, it would be logical to see the currencies of exporting countries strengthen against the currencies of importing countries. But of course, once again, there is never just one reason why a currency appreciates or depreciates.
The real value of currencies in relation to the competitiveness of the underlying economies
While the nominal exchange rate measures the value of one currency against another, this value gives no information about the purchasing power of one currency against another. The real exchange rate takes inflation into account in its calculation, and therefore reflects the real purchasing power of currencies.
Yet, while the evolution of real exchange rate peers offers a valuable guide to whether foreign exchange markets are over- or undervaluing a currency, understanding the determination of real exchange rates remains one of the most important and yet most difficult questions in international economic research.
Many economists have attempted to explain real exchange rate fluctuations by analyzing the differences between a number of independent variables. The Balassa-Samuelson effect is a well-known example among practitioners. This effect highlights the difference in productivity as a factor explaining real exchange rate trends.
So, when goods productivity growth slows down in rich countries and access to technology (a factor known to explain productivity gains) improves in developing countries, could we see emerging currencies appreciate over the long term?
The key role of the dollar
The U.S. dollar plays a key role in the global economy. It symbolizes the stability and confidence of financial markets. It is a reliable measure and a safe haven in times of economic instability. This pre-eminence transcends borders, with the dollar at the heart of international trade and finance. It was not without reason that in 1971, John Bowden Connally, then U.S. Secretary of the Treasury, told a European delegation concerned about fluctuations in the U.S. dollar: "The dollar is our currency, but it's your problem".
Conclusion
The foreign exchange market plays a crucial role in the global economy. It reflects the complex dynamics of different nations, offering investment opportunities as well as significant risks. The ability to interpret the forces at play with finesse enables market players to make informed decisions in an ever-changing global financial environment. In an upcoming article, we'll take a look at how an active bond manager can take advantage of the opportunities offered by the foreign exchange market, while remaining vigilant to the intrinsic risks.
1 Are emerging countries the new developed markets?
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