The fundamental drivers of currency appreciation and depreciation: Analyzing the nine core factors influencing exchange rate fluctuations

In the foreign exchange market, there are no eternal and unchanging prices. Every time a currency appreciates or depreciates, there is an underlying economic logic at play. To truly master forex trading, one must understand what forces are driving currency price changes.

The international forex market has a daily trading volume of trillions of dollars. The factors that drive this massive market are not singular but the result of multiple dimensions interacting. We have summarized nine key factors that influence exchange rates, covering short-term market fluctuations, medium-term economic cycles, and long-term structural changes.

Short-term Factors: Interest Rate Policies and Market Psychology

How Interest Rate Changes Influence Exchange Rates

Central banks’ most powerful tool is their interest rate policy. When a central bank decides to raise interest rates, foreign investors are attracted by higher returns, increasing demand for that country’s currency and pushing up the exchange rate. Conversely, the opposite occurs. The Reserve Bank of India once raised interest rates to prevent the rupee from depreciating continuously, which is a classic example of how interest rates directly impact exchange rates.

This mechanism may seem simple, but its deeper reason is: higher interest rates mean investors can earn more returns on their capital, making them willing to hold that currency asset. When large amounts of capital flow in, the currency naturally appreciates.

The Invisible Hand of Market Sentiment

Unlike quantifiable factors like interest rates, market sentiment is often an elusive force. When investors collectively favor a certain currency, their buying behavior reinforces itself, creating a self-fulfilling prophecy. Between 2005 and 2006, due to the US housing market being flooded with low-interest loans, the market generally expected housing prices to continue rising. This optimism, in turn, boosted the international demand for the US dollar.

Market sentiment is highly contagious—once investors start buying a currency, latecomers follow suit, forming a spiral of rising prices. This also explains why sometimes exchange rate movements can exceed what fundamentals would suggest.

Medium-term Impact: Multi-dimensional Economic Evaluation

Political Stability Determines Investment Confidence

Investors naturally prefer to invest in countries with stable political environments. A stable government not only signifies policy consistency but also suggests predictable economic growth. When a government actively implements reforms to improve living standards, economic vitality increases, and investment opportunities grow.

The Brexit referendum provides a negative example. On the day the vote results were announced, the British pound plummeted against the dollar. This was not because the UK’s economic fundamentals collapsed overnight, but because political uncertainty undermined investor confidence. Market aversion to unknown factors is often more intense than concerns over known risks.

Inflation Rate Reflects Changes in Purchasing Power

Investors automatically favor currencies with relatively low inflation rates. The logic is straightforward: if a country faces high inflation, its currency’s purchasing power diminishes in international trade, leading to long-term depreciation.

Zimbabwe’s historical case is particularly profound. When inflation soared out of control, its currency became almost worthless on the international market, and the Zimbabwean dollar became an object of avoidance for forex traders. This extreme example illustrates the decisive impact of inflation on currency appreciation and depreciation trends.

Government Debt Levels Test Investor Confidence

Imagine a heavily indebted borrower—would banks still be willing to lend to him? The same logic applies to countries. The higher the government debt, the more questionable the country’s repayment ability becomes, and the lower the willingness of foreign capital to flow in. When foreign investment decreases, demand for the domestic currency drops, leading to a weakening exchange rate.

One reason the Indian rupee faces depreciation pressure is that government debt levels have not decreased proportionally with rising oil prices. By observing long-term trends in government debt, investors can assess a country’s long-term currency appreciation or depreciation potential.

Employment Data Reflects Economic Vitality

Unemployment rate is the most direct indicator of economic health. High unemployment indicates stagnant growth and underutilized labor resources, casting a shadow on economic prospects. Under such circumstances, investors tend to reduce their holdings of that country’s assets, increasing downward pressure on the currency.

The US non-farm payroll report is a typical example. Whenever this report shows employment growth exceeding expectations, the US dollar index tends to rise rapidly. Strong employment data is interpreted as sufficient economic momentum, making investors more optimistic about the dollar’s outlook.

Capital Markets Reflect Economic Expectations

Stock market performance often leads economic reality. When the stock market declines over the long term, it usually signals investor pessimism about economic prospects. Conversely, sustained rises in capital markets indicate widespread confidence in the country’s economic growth.

Take China as an example. Since 2005, the strong rise of its capital markets has boosted international investor confidence in China’s growth prospects, leading to structural adjustments in the USD/CNY exchange rate. Prosperity or downturns in capital markets often precede changes in currency exchange rates.

Long-term Structure: Trade and Policy Frameworks

Trade Conditions Determine Long-term Exchange Rate Trends

If a country’s exports significantly exceed its imports, demand for its currency in the international market will continuously increase. Exporters need to convert foreign currency into domestic currency, which boosts the purchasing power of the domestic currency. Over the long term, countries with trade surpluses tend to see their currencies appreciate.

China’s trade conditions have remained positive for many years, maintaining relatively steady demand for the renminbi in the international forex market. Improvements or deteriorations in trade conditions can profoundly shape a country’s long-term currency appreciation or depreciation trend.

Currency and Fiscal Policy Frameworks

A country’s monetary and fiscal policy frameworks fundamentally reflect its attitude toward foreign investment. If the government adopts policies to attract international capital—such as lowering taxes, easing regulations, and simplifying investment procedures—large inflows of foreign capital will create sustained buying pressure on the currency.

Conversely, if policy environments turn protectionist or uncertain, foreign capital will flee. The fundamental reasons for currency appreciation or depreciation often depend on these deep policy frameworks rather than short-term fluctuations.

Integrated Perspective: Interaction of the Nine Factors

The nine factors influencing exchange rates do not operate in isolation but interact, reinforce, and influence each other. Strong employment data can prompt central banks to consider raising interest rates, which in turn attracts capital inflows, boosting stock markets and further reinforcing positive economic expectations.

Conversely, political uncertainty can turn market sentiment pessimistic, leading to capital outflows from equities, an increase in the debt-to-GDP ratio, pressure on the central bank to cut interest rates, and ultimately a cycle of currency depreciation.

For investors, understanding these nine factors and their logical relationships is equivalent to mastering the code to interpret the forex market. Before engaging in forex trading, a thorough analysis of these fundamental drivers of currency appreciation and depreciation will greatly improve the success rate of investment decisions.