How does currency value fluctuate? Analyzing the nine core drivers that influence exchange rate rises and falls

In the foreign exchange market, the appreciation or depreciation of currencies does not happen arbitrarily. To understand the impact of TWD appreciation and the logic behind other currencies’ fluctuations, one must recognize that: many factors determine exchange rates, but their effects occur over different time horizons. Based on their cycle of influence, these factors can be categorized into three types:

Short-term volatility drivers: interest rate policies, market sentiment
Medium-term adjustment factors: political risk, inflation rate, government debt, employment market, capital market performance
Long-term structural factors: trade balance, fiscal policy

How the Nine Major Factors Determine Currency Fluctuations

If investors want to profit from forex trading, they must understand what drives currency price changes. Here are nine key drivers shaping the global foreign exchange landscape:

1. Stability of the political environment

Currency traders tend to buy currencies of countries with stable political situations. When the ruling authorities implement policies that promote economic development and improve public welfare, the country’s economic growth outlook tends to rise. A stable political system means lower policy risks for the economy and greater growth potential.

Conversely, political uncertainty weakens currency attractiveness. The Brexit event is a typical example: after the Brexit referendum result was announced, the GBP/USD exchange rate plummeted, reflecting investors’ concerns about the UK economy’s prospects.

2. Central bank interest rate policy adjustments

Interest rates are a core tool of monetary policy. Raising interest rates increases the returns on holding that country’s bonds or deposits, attracting international capital inflows, boosting currency demand and exchange rates. Conversely, lowering interest rates reduces the currency’s attractiveness.

The Reserve Bank of India has used rate hikes to support the rupee’s exchange rate and prevent excessive depreciation. This illustrates the immediate impact of interest rate adjustments on the forex market.

3. Relative differences in inflation rates

Investors tend to hold currencies with stable purchasing power, i.e., those with relatively low inflation rates. If a country’s inflation rate is significantly below the global average or that of competing countries, its currency usually appreciates. High-inflation countries face depreciation pressures.

Zimbabwe experienced extreme hyperinflation, which drastically devalued its currency and ultimately led to its abandonment, serving as an extreme example of inflation’s destructive impact on exchange rates.

4. Employment market data performance

Employment statistics are important indicators of economic health. Falling unemployment rates and rising non-farm payrolls typically signal economic improvement, boosting investor confidence, increasing demand for the country’s currency, and pushing up the exchange rate. Conversely, worsening employment conditions lead to currency depreciation.

If the US non-farm payroll report exceeds expectations and is optimistic, the US dollar index often rises accordingly. This correlation has been repeatedly validated in the global forex market.

5. Government debt levels

High national debt can weaken investment appeal. Similar to excessive personal debt eroding trust from banks, high government debt reduces foreign investors’ willingness to allocate assets to that country, thereby depressing the currency. Before purchasing a country’s currency, investors often review its debt trends over many years.

One factor contributing to the pressure on the Indian rupee to depreciate is that government debt has not decreased despite rebound in oil prices, reflecting concerns over fiscal sustainability.

6. Stock market cycles

Capital market trends reflect investors’ outlook on the economy. A long-term rising stock market indicates strong corporate profits and optimistic economic growth, which in turn increases demand for the local currency. A sharp decline in stocks signals economic slowdown and puts downward pressure on the currency.

The Chinese stock market’s significant rise after 2005, coupled with the appreciation trend of the RMB against the USD, reflects a positive correlation between capital market prosperity and exchange rates.

7. Trader psychology and market expectations

Market sentiment, though difficult to quantify precisely, has a significant impact on short-term exchange rate fluctuations. When investors expect a currency to appreciate, their preemptive buying can further drive up the exchange rate; the opposite is also true. This self-fulfilling prophecy is common in forex markets.

Between 2005-06, the expectation of rising US housing prices driven by low interest rates attracted global capital inflows, indirectly boosting the USD’s appreciation.

8. Trade balance structure

Countries with trade surpluses (exports greater than imports) face upward pressure on their currencies because overseas buyers need to purchase that country’s currency to buy exports. A long-term trade surplus means limited supply of the currency, leading to appreciation. China, with frequent trade surpluses, has long experienced upward pressure on the RMB, attracting many forex traders’ attention.

9. Friendliness of monetary and fiscal policies

Governments implementing policies to attract foreign investment—such as tax cuts, deregulation, or investment incentives—stimulate international capital inflows and increase demand for the local currency. Conversely, countries that impose trade barriers or capital controls often see little or no currency appreciation.

Impact and Practical Considerations of TWD Appreciation

The above nine factors also apply to explaining the effects of TWD appreciation. Taiwan’s central bank’s interest rate policies, Taiwan stock market performance, trade surplus status, and political stability are all key variables influencing the New Taiwan Dollar’s movements. When Taiwan’s economic data improves and exports perform strongly, the TWD typically faces upward pressure, directly affecting exporters and exchange costs.

By understanding these nine major factors, forex traders can more accurately forecast currency trends. Remember: short-term market sentiment fluctuations, medium-term economic data shifts, and long-term structural factors all play roles. Combining analysis across these three time horizons enables more informed decision-making in the complex forex market.