Ensuring the power of national currencies is the key task of governmental monetary policies all over the globe. Achieving this goal is difficult because there are many details affecting national currencies, and some of these factors cannot be controlled by national banks or other institutions. For ordinary citizens, all these factors are unified under the term of economic stability. But let’s find out what actually determines this economic stability and how it directly impacts national currency power.
Trading Capacity of the Country
To begin with, the power of a particular unit cannot be estimated in a vacuum — only in contrast to other assets. This aspect shapes exchange rates, which aren’t fixed and heavily depend on the trading relationships between two nations.
These relationships between partnering states affect the trade balance and all the payments that were processed to receive certain goods or services. This forms a current account, and if it suffers a deficit, it means that a country’s expenditures on products from abroad are higher than its earnings. As a consequence, the authority needs to borrow capital from international sources. The constant flow of foreign money does not only reduce the price of exported goods but also stimulates the lowering of the national exchange rate, making the national currency weaker compared to others.
When exploring the world’s top currencies, you should have noticed that these are the ones issued in states where price fluctuations are minimum.
To understand how inflation affects currency power, we need to define this term. So, in simple words, inflation happens when the prices of products and services within the country go up and the buying power falls down. This correlation is expressed in percentage and if this percentage is high, this means that a currency unit can no longer be used to buy the same amount of goods as before. This results in the weakening of the national payment unit.
If a government manages to keep national inflation low, it will increase its buying power, which will positively impact trading capacity on international markets. As a result, exchange rates get stabilized, and the status of a unit becomes more clear for banks to borrowers.
As mentioned before, currency power is a changeable characteristic that is defined when comparing one unit to others. This contrast — exchange rates — highly depends on the monetary policy of a central bank and its actions when defining interest rates. When they hike, foreign lenders find the state more attractive because this condition means higher potential returns. However, the more foreign capital is involved, the weaker becomes a national currency.
Nevertheless, this step might appear necessary to counter growing inflation, which is often caused by external economic factors. The ongoing unprovoked Russian invasion of Ukraine is a good example of how global events stimulate national financial institutions to hike their interest rates in order to avoid surging inflation, which would be caused by the decreasing supply of many vital commodities, including oil, natural gas, aluminum, nickel, corn, etc.
The economic performance of a country is extremely relevant for foreign investors. If they see that the current productivity can bring them returns in the future, they will invest their money in those countries and will make a great contribution to the overall financial stability. This will eliminate the demand to increase interest rates, which will eventually lead to lower exchange rates.
However, if the opposite situation happens and big businesses aren’t attracted to the country’s policies, governments will have to seek foreign capital through borrowing from international financial institutions. This will catalyze the devaluation of the national currency and will lead to growing exchange rates.
National monetary conditions are determined by their national institutions — government and central banks. Consequently, if the nation faces political instability, this process will be slowed down, negatively affecting the general economic performance. This will also motivate foreign investors to draw their capital away from the country because of the fear of losing them all if the turmoil will appear to be too unexpected and extreme.
Poor political stability in a country can also negatively affect its trading relationships with international partners. A new government might simply reject promising initiatives due to its ideological beliefs and future development plans.
The Bottom Line
On the whole, economic stability is a complex notion that depends on numerous factors, many of which, such as political situation and trading capacity, can be affected by non-economic factors. That’s why, when trading on foreign exchange, it’s important to follow the global news to be able to assess the current conditions in different countries. Never neglect the possibility to conduct a deep analysis of the economic stability in a country in order to make well-thought-out trading decisions.