Exchange Rate
Updated: Dec 17, 2022
Authors: Angelica S. Hunwick, Roland Ezekiel M. Devesa, Gabriel Angelo C. Abuel, Naomi Chyla G. Choo
Contributors: Jose Benjamin J. De la Cruz, Maria Angela T. Tabago
An exchange rate is a rate at which one currency can be traded for another, and it has an impact on international trade and money transfers (Chen, 2022a). It is not just relevant to people and companies doing business across borders, but it is an important economic measure that can impact ordinary people as well as a nation’s economy as a whole.
Exchange rates are important because they serve as the link between the local and international market for goods, services, and financial assets, and compare their prices quoted in different currencies. Movements in exchange rate can also affect inflation depending on how large of a component imports are in the balance of trade. A stronger peso lowers the local price of imported goods and import services, thereby resulting in a lower rate of inflation. The country’s external sector is also affected by the impact of exchange rate movements on foreign trade. When the peso appreciates, the number of goods being exported would likely drop, lowering the price competitiveness of the country’s exports. Lastly, the cost of servicing foreign debt is affected by exchange rates. Appreciation in peso would reduce the amount of local currency needed to buy foreign currency that is used to pay interest and debts (Bangko Sentral ng Pilipinas, 2020).
Understanding the Exchange Rate
Exchange rates are quoted between two currencies. For example - how many Philippine pesos (PHP) can be exchanged for one U.S. Dollar (USD)? The exchange rate as of October 8 is PHP 59.06, meaning that exchanging USD 1 would yield PHP 59.06.
Furthermore, the rates are impacted by two factors:
The domestic currency value
The foreign currency value
Exchange rates are essential since they take into account many economic factors and variables that can change for a number of reasons (Corporate Finance Institute, 2020):
Interest Rates
Currency value and exchange rates are affected by changes in interest rates. If everything else is equal, a higher interest rate in a domestic country will raise the demand for its domestic currency because more foreign investors will look to invest at a higher rate, bringing foreign capital into the domestic economy
Such is the case with the depreciation of Philippine peso today, and many other currencies including the British pound and Euro, as the US Federal Reserve has announced a series of interest rate hikes in quick succession to combat domestic inflation. This increased the demand for the US dollar compared to other currencies as US debt instruments became much more attractive to investors as their returns reached a ten-year high (Kerr et al., 2022)
Inflation Rates
Currency value and exchange rates are affected by changes in inflation rates. If everything else is equal, a country's higher inflation rate will result in less demand for its own currency because it loses value relatively more quickly than other foreign currencies
Government Debt
The government debt is the total amount of money borrowed by the government to cover deficits in the national budget. This can be borrowed from local or foreign creditors, individual or institutional. Since a nation with larger, unsustainable debt is perceived to have weaker fundamental macroeconomic conditions, including a possibility of having higher inflation in the near future, it is less likely to attract foreign capital (Park et al., 2020). This affects currency value and exchange rates due to weaker demand.
Political Stability
The value of a country's currency and exchange rates are influenced by its political situation because a nation with more political unrest is less likely to draw foreign investors. Investors are more at risk when there is political unrest because they are uncertain whether their investments will be safeguarded by ethical business practices or a robust legal system.
Export or Import Activities
Net exports and imports have an effect on the value of a currency and exchange rates. A domestic nation's currency will be in greater demand if it exports more goods than it imports, which will cause its exchange rate to rise in relation to other foreign currencies.
Effect on Investments and Industries
So how does movement in exchange rates affect industries and investments? On a national level, an increase in a country’s exchange rate means that there is a high demand for its goods and thus, for its currency (Lioudis, 2022). Now, a depreciation in a country’s currency, such as what is happening for the Philippine peso, decreases the price of the country’s goods and services relative to another country's currency. This makes imports more expensive and exports cheaper, which increases the attractiveness of exports of the country’s goods by foreign countries. This cycle helps in balancing the trade among nations and prevents huge changes in the exchange rate.
Movements in exchange rate do not only affect the trade between nations, but also industries including tourism and businesses. A depreciation of a country's currency can be considered a good thing for other sectors of the country, specifically for those dealing with foreign internationals such as the tourism department. But why is this the case?
A country with a weaker currency can potentially have a stronger tourism industry, as people from countries with higher currencies tend to be attracted to destinations where they have a higher spending power. Tourists will have the capacity to buy more with the same amount of money. To better explain, we will use the comparison of the U.S. dollar and the Philippine peso currency. The average exchange rate in the year 2021 was USD 1 = PHP 49.2756 while it is currently USD 1 = PHP 58.91. If a one night stay at a 5-star hotel in the Philippines costs PHP 15,000, American tourists would need only approximately USD 255 today as compared to USD 305 in the year 2021. Without accounting for inflation, this saves them USD 50 which they can use on other necessities for their trip, such as food, transportation and souvenirs.
For businesses, changes in exchange rates impact them in many main ways: including modifying supplier payments for inputs sourced from other countries and by influencing product sales to customers abroad (Kaye, 2017). Entrepreneurs who are mostly dependent on overseas suppliers for their raw materials and services are affected the most. To manage the effects of varying exchange rates, it is important to stay informed on the level and direction of the exchange rates that matter to businesses such as the currency of countries that they buy and sell goods from. When investing in companies, you may observe this in their balance sheets, as exchange rates may have varying results such as higher production costs, decreased sales if their products become too expensive for consumers, or conversely, it may also show better revenues if they are able to take advantage of the export market. This was observed in the case of Hyundai. The Korean carmaker posted an 18% increase in year-on-year revenues, and a 55.6% increase in net profits in Q2 2022 (Hyundai, 2022). This is despite selling 5.3% less units compared to the same period in the previous year because of the chip shortage from key manufacturers abroad and lockdowns in China. These results are attributed by the company to improved sales on their luxury models, but also because of favorable exchange rates which made their foreign sales worth more when converted to local currency as the Korean won depreciated against the dollar (Hyundai, 2022).
The Philippines’ foreign exchange policy follows the freely floating exchange rate system where the central bank of the country, the Bangko Sentral ng Pilipinas, leaves the value of peso to be determined by the supply and demand of foreign exchange market (Department of Economic Research, 2020). The fluctuations in the prices of various currencies have also given opportunity for investors to profit from Forex Trading, which is essentially exchanging one currency for another, usually called “currency pairs”, to take advantage of when and by how much it is anticipated to appreciate or depreciate (Chen, 2022b). This is a more direct way of profiting from exchange rates rather than waiting for its impact on the prices of other goods and services. To know more about the specifics of this trading activity, you may check out one of our past FinBits dedicated to the Forex Market.
Effect on Consumers
Depending on how often a country’s currency exchange rate changes, it can most certainly affect consumers directly in different ways. To understand this, we’ll need to talk about a concept called purchasing power. Purchasing power, also called buying power, is the value of a currency based on how much goods or services a single unit of that currency can buy (Hayes, 2022).
The Philippines is mainly regarded as a country that relies heavily on imports. According to the Philippine Statistics Authority [PSA] (2022b), the total amount of imported goods last July 2022 was valued at USD 12.139 billion, much larger compared to USD 6.211 billion worth of exports. What happens if the peso weakens as is the case in the past few months? If the peso further depreciates against the US Dollar, it costs much more to import goods from other countries, thereby pushing up the prices of many important goods and services. It then leads to a phenomenon known as inflation, characterized by a general increase in prices of products and services, and a decrease in the purchasing value of money. This is reflected by the corresponding rise in the Consumer Price Index (CPI), a primary measure of inflation which is obtained by comparing the current prices of a basket of goods and services most commonly consumed in an economy to prices from a base year. The reciprocal of the CPI multiplied by 100 is the purchasing power of the peso, indicating how much each peso is worth today compared to a few years ago (the base year). Exchange rates may not directly affect the domestic purchasing power of a currency but it can influence the buying power of a nation's currency when purchasing goods and services from another country (Ingram, 2019).
One clear example of this is the continuous increase in the prices of gasoline, diesel, and other related products, where we see gas companies charge as much as PHP 90 pesos for just one liter of diesel. Not only is gasoline more expensive compared to previous years, but expensive gas prices also translate to an increase in public transportation fare, and more importantly, it also translates to higher prices for commodities and services, among many others. The PSA (2022a) reported a 6.3% headline inflation rate for August 2022, based on the CPI which covers transport costs. This is well above the BSP’s 2-4% target range. If imported goods with volatile prices are removed from the CPI, a 4.6% core inflation rate can be seen, which is somewhat lower than the headline inflation. Conversely, if the peso strengthens against the US dollar, imports become much cheaper, and it translates to lower prices for consumers.
For exporters, the case is exactly the opposite. They actually benefit from a weaker currency, as it makes the products they export much cheaper, and in extension, it makes exports more competitive, which allows for higher sales for these companies and a greater potential to create more jobs, which can effectively induce growth for said country.
It is also worth mentioning that, in the context of the Philippines, a weakening peso makes the contributions of OFWs, or overseas Filipino workers, all the more valuable. OFWs usually remit their salaries and earnings in the form of foreign currency. The more foreign currency OFWs remit, it gives the country more foreign currency to use in purchasing imported goods. However, the benefit that remittances bring must be weighed carefully against the effect of a depreciating currency on inflation. If the increase in the CPI far outpaces the increase in the value of the money brought in by OFWs, then it would still pose a net harm for the average Filipino consumer.
Conclusion
For the reasons mentioned earlier and more, the exchange rate affects various sectors of the country more than we think. The exchange rate is an indicator of the performance of our economy relative to other economies, and it also gives us a glimpse of how much value our money has now. Given that the peso is continuously weakening and is forecasted to weaken further because of the US Fed’s interest rate hikes, the country should brace itself for soaring inflation and capital outflow, once again hurting its citizens if the government is unable to counter it. However, it does present opportunities for local manufacturers to make gains in the export market, but the situation can only be turned into a positive one if the authorities are capable of steering the economy such that there is an environment conducive for the growth of Filipino industries.
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