January 12, 2017



The value of a currency is determined in foreign exchange market either by the method of ‘floating system’ or ‘fixed exchange rate system’, or sometimes is called ‘pegged exchange rate’.

In this article, the discussion refers to the floating system. Fixed exchange rate or pegged exchange rate system will be discussed in the next series.

Determining the value of currency in ‘floating system’

Most countries in the world use floating system in determining the value of their currencies. In this system, the currencies are float in the foreign exchange market (FOREX) whose values are determined by supply and demand of the currencies as compared with the value of other currencies. If the demand for a currency increases, the value will increase, and vice versa.

FOREX is a currency market where the value of currencies is determined either by the method of ‘floating system’ or ‘fixed exchange rate system’, which sometimes called ‘pegged exchange rate’.

Usually the value of a currency is compared against other world's major currencies, such as USD ($), pound sterling (£), German mark (€) and yuan (¥). In many cases, the value is compared to the US dollar as the currency is frequently used in international trade transactions.

Where is the FOREX headquarters?

Unlike the stock market, which usually have their own buildings, such as Bursa Malaysia, at Exchange Square, Bukit Kewangan Kuala Lumpur, or the New York Stock Exchange (NYSE) at Wall Street, FOREX does not have headquarters or owned buildings. The largest financial market in the world is operating on decentralized basis and the transaction is done online via electronic or telephone system.

What are the contributing factors to currency demand?

As mentioned above, the value of a currency is determined by supply and demand in foreign exchange market (FOREX). Demand for the currency is influenced by many factors. These factors are summarized as follows:

i. The trade balance, which is the difference between the values of export and import. The trade balance indicates the state of external trade of a country, either in surplus, where the value of exports exceeded imports; or in deficit, where the value of imports exceeded exports. The trade deficit indicates (a) reduction in demand for goods and services of the country in the market (b) reduction in demand of the currency for trade transactions in FOREX, and (c) depreciating the value of currency in the market.

ii. Monetary policy, namely the policies set by the central bank, such as the supply of currency in the market and bank interest rate. Higher interest rate will increase the demand and value of the currency as it will give higher returns to lenders and thus increase the inflow of foreign capital. Higher interest rate also will increase the demand for currency speculation, and if the size is big, it will bring unintended consequences to the economy.

iii. Economic policy refers to the revenue and expenditure of the country, namely (i) a balanced budget, which means income equals expenditure, (ii) the budget surplus, i.e revenues exceed expenditure, and (iii) the budget deficit (sometimes called fiscal deficit) in which expenditure exceed income or revenue. The currency market reacts negatively to the countries with high fiscal deficit. The effect is reflected by the fall in the value of currency.

iv. Inflation reduces the purchasing power, reducing demand for the currency and thereby reducing the value of the currency.

v. Political stability. Exchange rate is highly sensitive to political instability of the country. Political instability will affect investor confidence and thereby the currency of the country. In this case, investors will usually convert the weak currency to strong currencies, such as USD and euro.

vi. Other factors, such as economic growth, employment, sales in the retail sector, and other indicators also affect demand for the currency.

The combination of the above factors contributes to the volatility of currency exchange rates for the countries that use floating system in determining the value of their currencies in the foreign exchange market (FOREX).

What is the system used in Malaysia?

Malaysia uses floating system in determining the value of ringgit. Malaysia had been using the pegging system, where ringgit was pegged to USD = RM3.80 on 1 September 1998, aimed at eliminating the ringgit funds abroad for speculative activities. On July 21, 2005, the pegging system of ringgit was abolished.

Why ringgit is depreciating now?

On January 4, 2017, the ringgit was traded RM4.49760 / USD, the lowest level since the Asian financial crisis in 1997/98.

As mentioned, there are various factors affecting the fluctuations of the value of a currency. These include economic and monetary policies, trade and political situation. Current issues also play an important role, such as the investors' decisions to sell the weak currency and buy the strong currencies, such as USD, following a decision by the United States to raise interest rates in 2017.

What is the impact of lower ringgit to us?

Devaluation of the ringgit means we have to pay more for goods and services imported from abroad or use of goods and services when we are abroad. For example, if we travel to London and rented a hotel room that cost $200 a night, when Malaysian ringgit was RM3.80 / USD, we only pay RM760.00 per night. But today when the ringgit fell to RM4.48 / USD we had to pay RM896.00 per night for the same room.