Inter-Play between Trade, Forex Rates and Interest Rates of an International Transaction

Free markets have a way of creating inherent checks and balances. This fundamental principle must be remembered while understanding the inter-play between interna­tional trade in goods/services, movement of forex rates and interest & inflation rates.

This is best understood by using an example. If India’s exports begin to grow rapidly, the demand for Indian currency (INR) would increase substantially since foreign im­porters would need INR to finance their purchases. Also higher influx of foreign currency (e.g. USD) would take place into the Indian markets.

Basic principles of demand and supply tell us that when a commodity (in this case INR) is more in demand vis-a-vis another commodity (in this case USD), then its price goes up. This means that the present scenario would result in ‘appreciation’ of INR. ‘Appreciated’ INR means that Indian exporters would get lesser Rupees for the USDs earned through their exports.

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Hence, in order to maintain their profits in INR, Indian exporters would have to increase their prices in USD, resulting in reduced price com­petitiveness of India’s exports in the International market. Thus we see that in a free market scenario, higher growth in exports leads to currency appreciation, which auto­matically slows down the exports of the country.

Now let us look into the inter-play between international trade in goods/services and interest/inflation rates. As discussed, increase in exports results in higher demand for the local currency.

This higher demand for INR means that the interest rates on that currency would go up since the lending institutions would be able to lend INR at higher rates to the manufacturers, local exporters and foreign borrowers of INR. Higher interest rates, combined with scarcity of local currency, leads to higher inflation.

Higher inflation within India would push up the manufacturing costs within the country, again resulting in lowered price competitiveness of Indian .exports. This is the second way in which automatic free market dynamics come into play to reduce excessive growth in exports of a country.

Thirdly, higher interest rates in INR would attract international players in money markets to convert their USD (and other currency) funds into Indian currency and invest in Indian money markets to benefit from comparatively higher interest rates here.

Again, this would result in higher demand for INR and an influx of USD (and other foreign currencies like Euro, Yen Pound Sterling etc.) into Indian monetary system. The end effect of this would be similar to that discussed in the first scenario- i.e. INR would appreciate, resulting in lowered competitiveness of Indian exports in the international market.

Here we must also note that, as discussed above, since higher interest rates within a country result in appreciation of currency of that country, in the long run the forex movements (depreciation of USD against INR, in this example) would tend to negate the benefits accrued to the foreign investors who moved their funds from foreign currency into India. It is on this forex movement prediction and expectation that currency market speculators base their business on.

Thus we see that International trade, forex markets and interest/inflation rates are closely interrelated and, in a free market scenario, tend to balance out the fluctuations in each other. However, one must note that there are other factors beyond those discussed above that influence the movement of goods, forex rates and interest/inflation rates in the International markets.

These include inherent efficiency of production within the country, technological developments, political stability, government policy and physical, legal & financial infrastructure of the country etc.