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Money Know-How

What Is The Relationship Between Interest Rates & Exchange Rates?

What Is The Relationship Between Interest Rates & Exchange Rates?

What Is The Relationship Between Interest Rates & Exchange Rates?

This article is the second and final part of the series ‘Understanding The Relationship Between Interest Rates & Exchange Rates’. Read Part I 

In the real, non-bookish world, interest rates and exchange rates do not have a simple one-on-one relationship. Nonetheless, they do impact each other in important ways.

High interest rates indicate that a country’s currency is more valuable. From a foreign investor’s perspective, saving or investing in that country is more likely to yield better returns. Thus, this would increase the demand for that country’s currency. To take advantage of the high rates offered, they would move their funds there. When demand for a currency goes up vis-à-vis another currency (or currencies), it is said to strengthen or appreciate. When this happens, its exchange rate improves. A strong currency exchange rate is good news for its importers and bad news for its exporters.

The reverse is also true – when a country’s interest rates are low, its currency is considered less valuable, so its demand in the foreign exchange markets falls. This leads to its depreciation and results in a weak exchange rate vis-à-vis other stronger currencies. If this country imports goods from all these stronger-currency countries (in economic terms, when country A’s imports from Country B are higher than its exports to Country B, Country A is said to incur a trade deficit with Country B), the combined effect of its currency depreciation makes imports more expensive and exports more competitive. It also leads to economy-wide inflation in the country. When inflation rises, the purchasing power of the currency is reduced, domestic interest rates increase and borrowing becomes more expensive.

Consider this real-world example: September 2018 has witnessed a massive depreciation of the Indian Rupee (INR) against the US Dollar (USD). As a result, the INR is weaker than the USD, which makes imports from America such as cotton, diamonds, aircraft and computer software more expensive for India. This is because when Indian importers buy American goods, they pay for them in INR. Due to the INR’s devaluation, in real terms, the purchasing power of Indian importers has reduced. Therefore, they end up paying more for the same amount/type of goods they import from America. Importers pass on this increased cost to Indian consumers by raising their sale prices.

As noted at the beginning of this section, interest rates alone do not determine exchange rates and the value of a currency in foreign exchange markets. Other factors such as internal political stability, inflation, the overall balance of trade (the total difference between imports and exports across all its trading partner countries), gross domestic product (GDP) and government debt are equally important.

Knowledge Of Interest Rates & Exchange Rates: Why It Matters But Also Why It’s Not Enough

What Is The Relationship Between Interest Rates & Exchange Rates?

Even if you understand concepts like interest rates, exchange rates, inflation, etc., mere knowledge alone is not enough to increase your financial health and well-being. Knowing how to apply this knowledge is more important unless you’re simply cramming for an Economics or Finance exam!

Here are some tips to help you take advantage of interest rate and exchange rate fluctuations for your personal gain:

How To Take Advantage Of Interest Rate Changes

What Is The Relationship Between Interest Rates & Exchange Rates?

1. Understand Your Own Profile – Are You A borrower Or A Lender?

When domestic interest rates are high, it offers an advantage for lenders and a disadvantage for borrowers. Loans and credit card payments become more expensive so you should avoid being a borrower. When rates fall, you can apply for that short-term personal loan or go on a credit card-fuelled shopping spree because your repayment burden will be lower.

At the same time, high interest rates make investments very attractive, so you should be a lender. Invest in fixed-income securities like corporate/government bonds or deposits that lock in the high interest rate so you can earn more on your investments even if interest rates eventually fall.

2. Buy Low, Sell High On The Stock Market

This is probably one of the biggest clichés in the financial world, but it’s a cliché because it’s true.

When interest rates are high, businesses and consumers cut back on spending. Businesses turn to the market to borrow and release more equity, so stock prices fall. This would be a good time to buy stocks.

When interest rates fall, firms turn to debt financing (cheap bank loans) instead of equity financing. In other words, they will borrow more from banks and less from the market (i.e. stockholders). Therefore, stock prices go up and you are more likely to earn a profit by selling.

How To Take Advantage Of High & Low Exchange Rates?

What Is The Relationship Between Interest Rates & Exchange Rates?

1. Hedge Your Bets: Buy Or Sell Foreign Currency

A rising home currency erodes the returns you can earn on a foreign currency. So when the exchange rate is in favour of your home currency, buy more of the foreign currency (again, the same buy low-sell high philosophy which has already been covered above). Conversely, when a foreign currency is gaining on your home currency, it indicates a good time to sell that currency so your profit, i.e. returns, will be higher (assuming you bought the foreign currency at a lower rate than you’re selling it at!)

2. Buy Or Sell Foreign Goods: Think Like Importers & Exporters!

You can take advantage of a favourable exchange rate differential by buying foreign goods. And if you take a vacation to a foreign locale with a plunging currency (compared to your own), you can enjoy low prices on top of good exchange rates. Here, you act like an importer.

If you’re considering selling some goods on foreign shores, a good time to do so is when the foreign currency is stronger than your own. In this case, you are an exporter.

You Might Also Want To Read: What Is Foreign Exchange Risk & How To Minimise It

3. Make Foreign Investments

In theory, money tends to flow to currencies that pay the highest interest, earn the best returns or provide the maximum profits. In practice, the stability of the underlying business and political climate is an important catalyst of this phenomenon. Nonetheless, a country with a depreciating currency provides a locational advantage because it has to give higher returns to attract foreign investment. So when the exchange rate between your currency and a foreign currency is high, your purchasing power is higher relative to that country. Therefore, you should invest in that country and take advantage of potential high rates of return.

4. Invest In Hedged Instruments

Hedging adds a degree of certainty to future costs, allowing an investor to fix the purchase price and minimise the possible future losses due to exchange rate variations. If you have foreign investments, leave the exchange rate risk ‘unhedged’ when your local currency is depreciating against the foreign-investment currency and hedged if your currency is appreciating vis-à-vis the other currency. Hedged overseas assets such as currency mutual funds, Exchange Traded Funds (ETFs), currency options, futures and forwards are good instruments to reduce risk, diversify investment portfolios and improve returns.

5. Use A Low-Cost Remittance Service Like InstaReM To Transfer Money Abroad

When it comes to overseas money transfers, exchange rate volatility is not the only loss-inducing factor. Such transactions can involve hidden costs and Telegraphic Transfer (TT) fees which can increase the burden on the sender. The exchange rate may also include a margin cost, which can be quite prohibitive and usually varies from one provider to another. These costs could make your forex investments and payments more expensive and cut into your future profits.

InstaReM Guarantees Zero-Margin FX Rates, No Hidden Charges & Best Transfer Amount.

Plus, the sign-up procedure is simple, and transfers are straightforward and hassle-free. All you have to do is sign up, upload the relevant documents, get your account verified and start transacting. Your recipient typically gets the money in 1-2 business days.

We hope that the information in this article helps you to make sound financial decisions and build a comfortable corpus for your bright future.