What is an exchange rate?

An exchange rate is the price ratio between two currencies, indicating how much of one currency can be exchanged for another. For example, if the USD to CNY exchange rate is 6.75, it means you need 6.75 Chinese yuan to buy 1 US dollar.

As a commodity, a currency's price in the domestic capital market is its interest rate, while in the international capital market, its price is the exchange rate.

Generally, when the demand for a currency increases, its exchange rate rises. For instance, when China's economy performs well with abundant domestic investment opportunities, foreign capital flows into China, increasing the demand for RMB. This leads to RMB appreciation. Therefore, a country's exchange rate largely depends on its economic conditions.

There are two main methods for determining exchange rates:

1. Floating Exchange Rate:

Under a floating exchange rate system, the exchange rate isn't government-determined but fluctuates freely based on foreign exchange market supply and demand. For example, when tourists worldwide visit Singapore - Chinese using RMB, Japanese using yen, and British using pounds to buy Singapore dollars - the increased demand raises the Singapore dollar's value against other currencies. Currently, China, the US, UK, Japan and others primarily use floating exchange rates. Governments may intervene when excessive fluctuations affect the economy.

2. Fixed Exchange Rate:

Fixed rates are government-determined, establishing a constant ratio between domestic and foreign currencies. For example, from 1994-2005, China fixed the RMB-USD rate at 8.27:1. Saudi Arabia maintains this system within fixed ranges, as do some Caribbean tourist-dependent islands pegging their currencies to the USD. Fixed rates provide stability but may cause trade imbalances.

Key factors influencing exchange rates include:

1. Interest Rates

Expected interest rate hikes attract foreign capital, increasing currency demand and value.

2. Inflation

Exchange rates directly reflect purchasing power. Higher inflation devalues currency, lowering exchange rates, and vice versa.

3. Economic Growth Rate

Political and economic stability with positive outlook increases currency value.

4. Foreign Exchange Reserves

Higher reserves typically strengthen a currency's exchange rate.

5. Balance of Payments

Trade deficits usually depreciate domestic currency while appreciating foreign currency. For example, China-US trade tensions reducing Chinese exports temporarily depreciated RMB against USD.

6. Macroeconomic Policies

Particularly fiscal and monetary policies significantly impact exchange rates.