Question

How fluctuations in the exchange rate impact capital projects.

Answer 1

Foreign capital will tend to flow into countries that have strong governments, dynamic economies and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.

Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors buy, sell and trade overseas securities. FDI is a critical source of funding for growing economies such as China and India.

Governments greatly prefer FDI to foreign portfolio investments, since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon, referred to as “capital flight," can be sparked by any negative event, including an expected or anticipated devaluation of the currency.

Inflation

A devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since, a 20% decline means a 25% increase to get back to the original price point.

Interest Rates

As mentioned earlier, the exchange rate level is a key consideration for most central banks when setting monetary policy. For example, former Bank of Canada Governor Mark Carney said in a September 2012 speech that the bank takes the exchange rate of the Canadian dollar into account in setting monetary policy. Carney said that the persistent strength of the Canadian dollar was one of the reasons why his country's monetary policy had been “exceptionally accommodative” for so long.

A strong domestic currency exerts a drag on the economy, achieving the same end result as tighter monetary policy (i.e., higher interest rates). In addition, further tightening of monetary policy at a time when the domestic currency is already unduly strong may exacerbate the problem by attracting more hot money from foreign investors, who are seeking higher yielding investments (which would further push up the domestic currency).

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