What makes currencies and exchange rates fluctuate?

Currencies and exchange rates will always be intertwined. That's because an exchange rate is a comparison between two different currencies. When one currency’s value changes, it affects its exchange rate with another currency.

It's why one pound can be worth 65 Philippine pesos today but something different tomorrow. Keep reading to discover what causes currency fluctuations and how they can affect your small business.

What causes currencies to fluctuate?

Currencies fluctuate based on the supply and demand for them.

Like any other commodity, when a currency is in high demand and short supply, the more people are willing to pay for it. On the flip side, when there's an abundance of currency in society, the less valuable it becomes.

Governments often increase and limit the supply of currency in circulation to manipulate its value. But why change the value of a currency?

Central banks will sometimes devalue (increase supply) or appreciate (limit supply) its currency for many reasons. For example, if a government’s debt repayments are fixed, a weaker currency makes these payments less expensive over time.

If you do business in healthy and stable economies like Norway and Japan, you’ll hardly notice currency fluctuations. That’s because there’s little need for their governments to manipulate their currencies.

That’s not the case with countries undergoing political upheavals. In the UK, Brexit and its unpredictable trade implications sent the normally stable Pound sterling dipping in value. Similarly, the potential outcome of a US election usually sees the dollar yo-yo in value.

So what are the other reasons why currencies fluctuate - and what could they mean for your business?

Inflation

Inflation is the rate at which prices rise. Generally speaking, the cost of goods is always going up. Inflation measures the rate of this increase. If six pens cost £1 last year and £1.05 this year, the inflation rate was 5%. As £1 won’t get you six pens anymore, inflation generally means you get less for your money.

Interest rates

Interest rates affect how consumers borrow money. Higher interest rates mean people are reluctant to borrow money due to the high cost of repaying it. Lower interest rates mean more money is borrowed as it’s cheaper to pay back. When interest rates are low, currencies can drop in value. That's because lenders such as banks get low returns on investments in that currency.

Money supply

The money supply is the total amount of money that’s in circulation in a country. If there’s a lot of currency going around, the value of that currency will decrease against other currencies and the exchange rate will decrease. An increased money supply is connected to low interest rates as more supply means lower demand.

Government debt

When a country has high national debt, its currency can fall in value. Normally, to help repay the debt, the central bank will increase the money supply in the country. However, more money in circulation usually leads to inflation which in turn affects exchange rates.

Terms of trade

The terms of trade is the ratio of export prices to import prices. A country's terms of trade improve if the prices of its exports are more than its imports. In other words, the country makes more money than it spends. An increase in revenue usually results in a higher demand for the local currency.

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How to protect your business against currency fluctuations

It’s usually impossible to prevent or predict currency fluctuations. In cases where they could affect your bottom line, you should have a safety net in place. Below are some ways you can protect your business from exchange rate volatility:

Set up a rate alert

Similar to limit orders and forward contracts, rate alerts let you pick a favourable exchange rate for your transfer. Sign up for Azimo’s rate alert feature and they’ll notify you whenever your preferred exchange rate is reached. For example, if you’re paying a supplier in Poland, you can set up an alert for £1 = ₦ 5.50 PLN.

Whenever the exchange rate reaches this point, Azimo will let you know. After that, you can simply register with Azimo or log in to your account to complete your transfer.

Limit your number of currencies

By reducing the number of your trading currencies, you’ll reduce the risk exchange rates have on your business. You won’t have to worry about any major impact on your business resulting from exchange rate changes. If necessary, try to set your prices in your own local currency.

Use fixed contracts

Fixed contracts are another great way of avoiding currency fluctuations. Avoid being at the mercy of volatile exchange rates by agreeing on a sale price with a fixed contract. Many businesses and suppliers use fixed contracts to limit these risks while locking in prices for upcoming sales.

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