Discover the factors that influence exchange rates

Last July 12, the Philippine peso fell to its weakest against the US dollar since November 2004, closing at 56.37. During intraday trading, the peso touched its record high of PHP 56.45, a level last seen in October 2004.

So what’s causing the peso to increase or decrease in value? Before we answer that, let’s define a term that we often read about in the news or hear on news broadcasts.

What is an exchange rate?

An exchange rate tells you how much of a country’s currency you can buy for each unit of another currency. For example, if the peso to US dollar exchange rate is 50, you will get PHP 50 for every USD 1 you exchange.

Movements in exchange rates can make a big difference to the amount you get from a currency exchange. If the US dollar strengthens or appreciates and the Philippine peso weakens, the exchange rate will fall, meaning you will need more pesos to buy a dollar.

Conversely, if the US dollar weakens or depreciates and the Philippine peso strengthens or appreciates, the exchange rate will rise and you will need a smaller amount in pesos for every dollar.

Why do we exchange currencies?

The most common reasons we exchange currencies include travelling or sending money abroad. However, currencies are exchanged on a much greater scale for other reasons, including trade—buying goods and services from another country and investment.

There are several factors affecting the exchange rate:

Inflation and interest rates

Rising prices of goods and services are healthy for an economy as it shows increasing demand versus supply. However, too much inflation can be a problem, as goods and services become less affordable.

Central banks such as the Bangko Sentral ng Pilipinas (BSP) consider the country’s inflation rate when setting interest rates. If inflation is below its target level, a central bank may look to cut interest rates. Lower interest rates make it cheaper to borrow and less rewarding to save, reducing demand and slowing inflation.

Higher interest rates can increase a currency’s value. They can attract more foreign investments, which means more money coming into a country and higher demand for the currency.

Trade

A country’s trading relationship with the rest of the world can also affect its currency. Countries that export more than they import, or those who have a trade surplus, will typically have stronger currencies than those with trade deficits.

If businesses abroad buy goods and services from the Philippines, they will typically pay in pesos. The more a country exports, the higher the demand for its currency will be.

Market expectations

Taking into account the above factors, market expectations play a big part in exchange rate fluctuations. An unexpected interest rate cut or increase could have a significant impact on exchange rates.

The BSP holds regular Monetary Board (MB) meetings, where the MB members decide whether to raise, cut, or leave rates unchanged. Similarly, in the US, the Federal Open Market Committee (FOMC) holds regular meetings to discuss monetary policy, including interest rates.

Who are the winners and losers?

When the US dollar rises in value compared to foreign currencies, Americans get more bang for their buck when traveling abroad. A stronger dollar also means lower prices for imports into the US, which is key to the central bank’s goal of bringing down inflation.

While a booming dollar may help calm inflation in the US, it has the opposite effect in other countries, where weakening currencies are driving up the cost of imports, particularly oil, which is priced in dollars.

Lastly, investors often turn to safe-haven currencies, such as the dollar, when economic conditions in a country turn less-than-ideal for them.

What is happening today?

Much of the dollar’s rise we see today can be attributed to the US Federal Reserve. In its quest to fight inflation, the Fed has been hiking interest rates faster than other central banks around the world.

Higher interest rates make the US more attractive to investors looking for a return, and those inflows have pushed the dollar even higher. Today, the fundamental drivers for the peso include the Philippines’ worsening current account deficit, higher oil prices, and the more aggressive US Fed policy tightening.

Moving forward, pressure is continuously mounting on central banks around the world to hike rates in line with the Fed and cut some of their currencies’ losses against the greenback.

GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She is also a recent graduate of the Bank’s Financial Markets Sector Training Program (FMSTP). She holds a Master’s in Industrial Economics (cum laude) from the University of Asia and the Pacific (UA&P). She takes a liking to history, astronomy, and Korean pop music.