The currency market is the biggest and most liquid of financial markets. However, its purpose is hardly understood by laymen. Unlike an equity market, which is mainly focused on facilitating established companies to raise capital from a large number of investors, Forex market serves a multitude of purposes. The guide below explains the importance of the FX market and its role in shaping a country’s economy.
The importance of the Forex market can be understood by studying its role in a country’s economy. The foreign exchange market primarily exists for catering the currency needs of exporters, importers, and travelers. Unlike equity markets, the currency market is not an investor oriented market. Investors are a must for an equity market to function. Instead, an investor requires the existence of the Forex market to make overseas investments. Irrespective of participation from investors and speculators, the currency market will continue to operate. The Forex market is required for the following critical functions that drive the economy of a country.
International trade
Exporters will have a need to convert the payments received from an overseas buyer into domestic currency. Likewise, importers will have a need to convert the domestic currency into the US dollar for purchasing goods abroad. Additionally, large business enterprises will have a need for the US dollar to establish their branch, warehouse, or factory in another corner of the world. Even for the completion of a merger or an acquisition deal, a currency conversion is a necessity. Such requirements can be met only through the Forex market.
Financial instrument settlements
Many a times payments are sent as financial instruments (checks, demand drafts, letter of credits, international fund transfers, etc.) from one country to another. While the transaction process is complex and may involve more than two banks, it is the Forex market, which determines the exchange rate used for determining the amount to be credited to the recipient’s account.
When a country extends loan to another country for development projects, credit lines are usually opened favoring companies involved in the project. Even such instruments are processed using the exchange rates prevailing in the FX market.
Likewise, a country might have invested in the debt instruments issued by another country (for example, US Treasury notes). Alternatively, it might be a company or an investor who would have invested in a bond issued by a company operating in another country. When the instrument is redeemed, the final amount credited in domestic currency is based on the exchange rates prevailing in the Forex market.
Hedging
When an exporter receives order from another country, the product may not be shipped immediately. Thus, buyers open a letter of credit guaranteeing payment. As per contract terms, an exporter would ship the product in 45 to 60 days, usually. In the meanwhile, the domestic currency could gain or lose strength against the greenback. That means, the exporter may or may not realize the actual amount he intended to earn while preparing the quote to the end buyer. In the worst case scenario, an exporter may even incur a loss. To avoid such untoward incidents, an exporter can lock the exchange rate by entering into a contract with the transacting bank, which will use the Forex market to hedge the position and safeguard its interests.
Hedging is also done in the Forex market by investors who have bought riskier assets outside the country they reside. Notably, when political tensions between two countries heighten (the USA and North Korea, for example), investors would look for safe haven assets such as the Japanese yen and the Swiss franc. Without Forex market, such transactions are difficult to achieve in a short span of time.
Inflation control
Generally, central banks operating under a stable government hold large quantities of reserve currencies (euro, US dollar, British pound, Japanese yen, Swiss franc, Chinese renminbi) as part of their Forex reserves. The reserves are used to maintain stability in the economy. When the economy of a country starts flattening, the central bank will reduce interest rates. That will make the domestic currency unattractive to foreign investors. Central banks will also intervene (sell the domestic currency and buy the reserve currency) in the Forex market, if necessary, to ensure the domestic currency remains weak. The weak domestic currency will make exports competitive. Further, a rise in liquidity coupled with low interest rates will encourage spending. That will lead to economic growth.
Once the inflationary pressure starts building, the central bank will raise the benchmark interest rates. That will increase the attractiveness of the domestic currency to overseas investors. If necessary, the central bank will intervene (buy the domestic currency and sell the reserve currency) in the Forex market and ensure the domestic currency remains strong. As liquidity tightens, enterprises and individuals will think twice before spending. That will avoid overheating of the economy. Thus, central banks can use the Forex market to strengthen or weaken the domestic currency, if necessary, and ensure smooth functioning of the economy.
The world economy would come to a standstill without the Forex market, as there would not be a proper mechanism to determine the exchange rate of currencies. Further, it would also result in large scale manipulation of exchange rates by some countries, leading to huge imbalances in the world economy.
