The currency market is the largest and most liquid of all financial markets. However, it may be difficult for the average person to understand the purpose or function of this huge market.
The currency market plays many roles, unlike the stock market, which mainly focuses on facilitating fundraising for large companies by offering their shares to a large number of investors.
This article explains the importance of the forex market and the important role it plays within the national economy.
The forex market exists mainly to cater to the needs of foreign currency exporters, importers and travelers. However, the forex market is not the same as the stock market which is mainly driven by investors.
In other words, investors are a vital and indispensable part of the functioning of the stock market. On the contrary, it is the investor who needs the presence of the forex market to make his foreign investments.
In other words, the currency market can operate normally even in the absence of investors and speculators given the large number of important functions it performs within the body of the economy. In the following lines, we will try to list some of these vital functions.
Exporters need to convert the revenue they get in foreign currency from overseas buyers into their own local currency. Likewise, importers need to convert their domestic currency into US dollars, for example, to purchase goods from overseas countries.
And let’s not forget that big companies need to buy US dollars to establish their branches or build their warehouses and factories in other parts of the world. Also, currency conversion is a necessary step to complete mergers and acquisitions. All these needs can only be met through the forex market.
Settlement of financial instruments
Often payments are sent in the form of instruments or financial instruments (checks, bills of exchange, letters of credit, international transfers, etc.) from one country to another.
This type of transaction is characterized by complexity, as more than two banks may participate in its completion, and here comes the role of the forex market in determining the exchange rates used in determining the value of the amounts that will be added to the recipient’s account.
Another example. A country may grant loans to another country to finance development projects, and in this case lines of credit are opened to facilitate the work of companies involved in these projects. Even this type of transaction requires the use of the prevailing exchange rates in the forex market to process it.
Similarly, a country may invest in debt instruments issued by another country (such as US Treasury bonds). The investment in debt instruments may come from a private company or an investor through the purchase of bonds issued by a company in another country.
When foreign debt instruments come due, the final payment amount will be converted into the local currency according to the prevailing market exchange rates.
When an export company receives an order from another country, in most cases it will take some time to prepare the goods, and therefore they will not be shipped immediately. In this case, the buyer opens what is called a ‘documentary credit’ which constitutes a guarantee that the value of the goods will be paid upon receipt.
Depending on the terms of the contract, the exporter may ship the purchases within a period usually ranging from 45 to 60 days. During this period the value of the local currency may rise or fall against the US dollar, which affects the actual amount that the seller of the commodity will receive.
In some bad scenarios, the issuer may incur a loss due to exchange rates. In order to avoid such critical situations, the issuer fixes the exchange rate by entering into a contract with his bank requesting the use of the forex market to hedge against exchange rate fluctuations in order to protect his rights.
Hedging deals in the forex market also come from investors who buy risky assets outside of their countries of residence. For example, when political tension increases between two countries (such as what happened in previous periods between the United States and North Korea), investors resort to buying so-called safe-haven currencies such as the Japanese yen and the Swiss franc.
The unavailability of the forex market would have made it very difficult for investors to conduct this type of transaction within a reasonable period of time.
In general, central banks operating in stable countries hold huge amounts of foreign currencies (Euro, US dollar, British pound, Japanese yen, Swiss franc, Chinese renminbi) as part of their sovereign reserves.
These reserves are used to maintain the stability of the economy. For example, when a country’s economy begins to experience some difficulties, the central bank lowers interest rates, which in turn reduces the attractiveness of the local currency to foreign investors. Central banks also resort to intervention in the forex market (by selling local currency and buying foreign currency), if necessary.
The purpose is to keep the local currency at competitive levels. Also, the increase in liquidity in parallel with the decrease in interest rates encourages consumers to increase their spending, thus supporting economic growth.
But as soon as the inflationary pressures begin to accelerate, the central bank raises the interest rate, which in turn increases the attractiveness of the national currency in the eyes of foreign investors. If necessary, the central bank may intervene again in the currency market (buying domestic currency and selling foreign currency) to strengthen its local currency position.
Decreased liquidity will reduce the appetite of individuals and companies towards spending, thus avoiding the growth of the economy at rates that are stronger than required, which causes many problems.
In other words, the central bank can use the forex market to strengthen or weaken the national currency, as circumstances require, in order to ensure a smooth economic situation.