The currency market is the largest and most liquid financial market. 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 focuses mainly on facilitating the raising of funds 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 they play within the national economy.
The forex market exists mainly to meet the needs of foreign exchange 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 part and an indispensable necessity for 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 function normally even in the absence of investors and speculators given the large number of important functions it performs within the body of the economy. We will try in the following lines list some of these vital functions.
Exporters need to convert the revenue they receive in foreign currency from external buyers into their local currency. Similarly, importers need to convert their local currency into US dollars, for example, to buy goods from overseas countries. And don't forget that big companies need to buy dollars of America to establish its branches or build their warehouses and factories in other regions of the world. Also the currency conversion is a necessary step to complete mergers and acquisitions. All these needs can only be met through the forex market.
Reconciliation of financial instruments
Often is send payments in the form of instruments or financial instruments (cheques, bills of exchange and letters of credit, international transfers, etc.) from one country to another. This type of transaction is complex and may involve more than two banks, and here comes the role of the forex market in determining the exchange rates used to determine the value of the amounts to be credited to the recipient's account.
Another example. One country may grant loans to another country to finance development projects, in which case credit lines are opened to facilitate the work of companies involved in these projects. Even this type of transactions require the use of exchange rates prevailing in the forex market to address them.
Similarly, you might invest countries in debt instruments issued by another country (such as U.S. Treasury bonds). Perhaps investing in debt instruments of a private company or an investor through the purchase of bonds issued by a company in another country. When foreign debt instruments are due, the final repayment amount will be converted into local currency at market exchange rates.
When an export company receives an order from another country, in most cases it will take some time to process the goods, so they will not be shipped immediately. The buyer in this case open the so-called ’Letter of credit‘, which constitutes a guarantee of payment of the value of the goods when received. Depending on the terms of the contract, the exporter may ship the purchases within a period of usually 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 even incur a loss due to exchange rates. To avoid such critical situations, the issuer stabilizes the exchange rate by entering into a contract with the bank with which it deals requesting the use of the forex market to hedge against exchange rate fluctuations in order to protect its rights.
Hedging trades in the forex market also come through investors who buy risky assets outside the countries where they reside. For example, when political tension between two countries increases (such as 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 lack of the forex market would demand too much of investors ' ability to conduct these types of transactions during a reasonable period of time.
Control of inflation
In general, central banks operating in stable countries hold huge amounts of foreign currencies (Euro, US dollar, pound sterling, Japanese yen, Swiss franc, Chinese renminbi) as part of their sovereign reserves. These reserves are used in maintaining the stability of the economy. For example, when the economy of a country begins to experience some difficulties, the central bank resorts to lowering interest rates, which in turn reduces the attractiveness of the local currency to foreign investors. Resort central banks also intervene in the forex market (by selling domestic currency and buying foreign currency), if necessary. The purpose of this is to keep the local currency at competitive levels. Also, high liquidity in parallel with low interest rates encourages consumers to increase their spending, thereby supporting economic growth.
But as soon as 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 again intervene in the currency market (buying local currency and selling foreign currency) to strengthen the position of its local currency. Reduced liquidity will reduce the appetite of individuals and companies to spend, thus avoiding the growth of the economy at a stronger rate than required, causing 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.
There is no exaggeration to say that the world economy may stop in the absence of the forex market, since in this case it will lack appropriate mechanisms for setting exchange rates. Moreover, the absence of the forex market will lead to massive exchange rate manipulation that some countries may resort to in order to reap unfair competitive advantages, which may eventually lead to a significant imbalance in the global economy.