Impact Of Interest Rates On Currency

INVESTING IN FOREX MARKETS ? A PRIMER

-By Ajay Krishnan, Knowledge Partner EZ Wealth

We discussed two of the most important factors that affect currency prices in the last article. To complete the equation, we need to discuss the final and major fundamental factor that moves FX prices ? Interest rates.

Every country that follows the central banking system, has a certain interest rate associated with its currency. This is not fixed value and keeps changing over time, up and down. It is one of the most potent tools that a central bank has, to control and ascertain the economic conditions prevailing in the country.

Let?s take an example of two commercial banks:

Bank ?A? provides an interest rate on deposits/borrowings at 5% and Bank ?B? does it at 10%. Which of these banks will you deposit your savings in?

Bank ?B? of course. Why? They give you a much higher return on investment, that?s why!

Simple, right? Now imagine Bank ?A? was Reserve Bank of India and Bank ?B? the Bank of England (central bank of UK) and you are a millionaire US citizen with tons of money.

RBI is our central bank and all the commercial banks lend/borrow money to individuals and businesses with reference to its interest rate, which means interest rate of RBI can be taken as a yardstick of the return on capital made in the Indian economy.

Where would you ? the US millionaire with US dollars ? invest your money in? In India or the UK? Or in other words, the Indian Rupee or the Sterling Pound?

I believe the answer is simple – you will invest in UK because the Bank of England gives you a much higher interest rate on your capital.

Fig 1. Central Bank Interest Rates of different countries

What happens when more people from other countries invest in your economy? Your economy starts doing better, and your currency starts to increase in value! Didn?t we discuss in the previous article? Of course, we did, and it is now easier to understand why.

Fig 2. Countries with the highest interest rates

In that case, why can?t the RBI just keep the interest rates high and make India rich?

Good question. Well, if we kept the interest rates too high then you won?t be able to afford that home loan (or a car loan) from your bank and your friend won?t be able to afford that business loan he has been hoping to get for his start up. Also, if you have observed how businesses work, most of the operating costs and other expenses are financed through debt (a fancier word for loans) and credit. So, if the interest rates remain high, private enterprises will find it very difficult to borrow money to sustain their operations. And as we all know, slowdown or shutdown of businesses is never a good thing for the economy.

Not to mention that we may not be able to pay back the foreign investors such huge amounts of interests earned, if our economy does not perform according to expectations. These are all factors that prevent RBI from raising interest rates too high.

Another complex variable now gets added to all this: Inflation.

As a nation?s economy strengthens over time, prices tend to rise as the consumers are able to spend more of their income. The more we make, the better our vacations can be, and the greater amount of goods and services we are able to consume. This creates a loop where more money chases roughly the same amount of goods which can lead to higher prices for those goods. This rise in prices is called inflation. High inflation leads to a loss of value in your currency ? as now you get less for the same amount of money. It affects everyone, for worse.

Fig 3. India?s inflation rate between 2000-2016

So, to get a grip on inflation RBI will increase (or tighten) interest rates ? which now makes it more expensive for you to buy homes, cars, spend on credit cards and in general take on any additional debts. Less spending means lower inflation.

But while this reduces inflation, it again works against businesses like we discussed above, as it becomes more expensive for them to borrow money to conduct operations. This will eventually lead to a slowdown in the economy. So, once the RBI is convinced that inflation is under control, they will slowly start reducing (or easing) interest rates. This cycle continues forever.

Due to this cycle, you will see that currency prices will also follow a cyclical trend in the short to mid-term periods. But in the long term (especially for INR), it finally comes down to the first two fundamental factors we discussed in the previous post ? Current Account Deficit and Exposure to Commodities.

Now you know why RBI?s interest rate policy is watched so closely by investors ? both domestic and foreign alike. You will also see considerable fluctuations in currency prices around the time of the monthly and quarterly RBI council meetings ? mostly in anticipation of a rate hike or a rate easing.

That covers Forex fundamentals for you! Before we get into technical factors, we will learn the various terms used in the Forex market.

Next: Forex jargon ? Spreads, Margin and Leverage