Foreign exchange

Foreign exchange is the trading of one country’s currency for another’s. There are many reasons why this must be done in the normal course of business. For example, a company may need a foreign currency to purchase items priced and sold in another currency. Also some people (often poorer people) see holding the currency of another country as a hedge against the INFLATION in their own currency. Most U.S. currency is held outside the United States, probably for this reason. Many countries try to manage the rate at which their currency exchanges with other countries. A too-weak currency makes the purchase of foreign goods more expensive and indicates a weak economy. A too-strong currency makes the purchase of foreign goods cheaper, leading the country’s citizens to buy IMPORTS instead of domestically made goods. (The 1994 PESO CRISIS in Mexico is an example of what happens when a currency becomes overvalued.) Some countries try to control currency value fluctuations by establishing fixed or legal EXCHANGE RATES that currency exchanges must use. This usually produces devastating results in the local economy. In most cases there emerges an illegal black market where the common people and small businesses exchange the country’s currency. The degree of seriousness of this situation depends on how vigorous the government enforces the official exchange rate. In some cases an “official” exchange rate is set, but everyone, including the government, uses the unofficial market rate. This has little impact on the economy, allowing the country’s officials to delude themselves that the economy is behaving well. On the other hand, if the government strictly enforces the dictated exchange rate, large business may not be able to function in the country, and no foreign investor would dare invest money there. A less disruptive way to manage the exchange rate is for the government’s central bank to manage it by open-market activities. The central bank will purchase its own currency in an attempt to raise its value in the market and then sell its currency in an attempt to lower its value. This behavior is less troublesome but is usually only effective to manage minor currency fluctuations on an ongoing basis. It is largely ineffective in managing large shocks to an economy. For this reason, small countries are becoming more wary of draining their foreign-currency reserves by buying large amounts of their own currency to support its value. The reasons for the foreign-currency exchanges discussed above are the results of normal economic activity within a country. However, for years foreign-exchange markets (some very informal) have existed for solely speculative reasons. People in France are buying Indian rupees from people in Australia solely in anticipation of gains in the value of Indian rupees. These speculative exchanges combined with the routine ones discussed earlier have produced a financial market of gigantic proportions. The worldwide foreign-exchange market has a typical volume of $1.5 trillion per day, more than three times the amount of stocks and BONDS traded in the United States per day. Unlike STOCK MARKETs, which have central exchanges, the foreign-exchange market has no physical location. It operates 24 hours a day, solely through an electronic network of banks, CORPORATIONs, and individuals. Even though there are some regulations on the participating banks and corporations, the foreign-exchange market is virtually unregulated.