Political Stability

How Political Stability Impact the Forex Market

Every country has a government which acts as the pilot to drive the steering of the economy and the well-being of its people. A government may have ideological leanings which dictate the kind of policies it will churn out. There are governments that will favour a free market environment in its totality. Though there are not many of them now, some governments promote a centrally planned economy. There are those that prefer to run a mixed economy, retaining a mix of the two extremes to varying degrees. Each ideological leaning will definitely give rise to certain policies that will be viewed by the investment community as either investment/trade positive, or investment/trade negative.

Governments also come and go. It is possible for a government with certain policies that are deemed as good for investment to be voted out, and another government without the same sentiments as the previous one to be come in. Then of course there are the occasional coup d’états that occur in countries with unstable democracies that completely turn around the wheel of progress and drive the investment community into hibernation.

It is thus not very difficult to see the connection between the stability of a country and the state of its currency. Investors only come into a country to invest when there are policies that favour returns on those investments. To do this, investors will have to purchase large amounts of the local currency in order to utilize it within the local market. This favours a demand-driven rise in the local currency’s valuation.

Factors Affecting Trade Balance

Factors that can affect the balance of trade include:

a)    The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing economy;

b)    The cost and availability of raw materials, intermediate goods and other inputs;

c)     Exchange rate movements;

d)    Multilateral, bilateral and unilateral taxes or restrictions on trade;

e)    Non-tariff barriers such as environmental, health or safety standards;

f)     The availability of adequate foreign exchange with which to pay for imports; and

g)    Prices of goods manufactured at home (influenced by the responsiveness of supply)

Currencies Most Prone to Political Stability Issues

The Euro has to come up for mention in this regard. Many authorities had long questioned the wisdom in allowing a common currency for a region made up of countries with different financial strengths, different economic strengths and variant cultural values. This hypothesis was tested to the core when the sovereign debt crises in Europe broke out. In Europe, there were countries who had very expansive social spending structures in place from decades past, and when these countries were hard hit by the global financial crisis, their ability to continue their social spending was seriously jeopardized. With their funds running out, even the ability to maintain sovereign debt obligations (bond payments to investors) was put in great jeopardy. 2010 – 2013 were very trying years for the Euro as the crises in Spain’s banking sector, Greece, Portugal and Ireland put severe strain on the Euro, causing it to lose ground against major currencies.

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As the ECB, IMF and European Parliament pushed for austerity, a government change in France which saw the exit of pro-austerity Nicholas Sarkozy and the entrance of an anti-austerity socialist government of Francois Hollande, shook the confidence of investors which led to a sell-off in the Euro when the election results were announced.

Why is Political Stability Relevant to Forex Traders?

Political stability guarantees continuation of economic policy. When the polity is unstable in several countries, it generates fear in the market, leading to a risk-off sentiment. In a market with risk-off sentiment, the goal shifts from profit-making to capital preservation. This leads traders to seek safe-haven investments such as gold, the US Dollar and up until 2011, the Swiss Franc.

The increased valuation of the Swiss Franc created problems for the Swiss economy, causing it to lose its export competitive edge as a result of Swiss exports being more expensive to pay for with a stronger Swiss Franc. This led to the intervention by the Swiss National Bank in September 2011, pegging the CHF at a minimum value of 1.2000 to the Euro. The Swissy lost ground across all pairings simultaneously. This has effectively narrowed the range of safe haven investments that traders can use to safeguard their capital.

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This has also affected the gold market. A safe-haven induced gold rush caused gold prices to hit all time highs at beyond $1,800. However without any more fundamentals to keep prices up there, gold prices started to tumble in 2013. Gold now stands at a little more than $1,230 an ounce.

Another instance of the relevance of political stability to forex traders is in the commodity currency-backed economies. The following events have occurred to shake up the dynamics in these economies:

a)    Civil war in Cote D’Ivoire sent cocoa prices soaring in 2012.

b)    Various strikes by mine workers in South Africa have caused platinum prices to skyrocket.

c)     The civil war in Libya, producer of 2% of the world’s crude oil, caused prices to spike almost overnight. At the end of that war 11 months later, crude prices had registered a 50% increase. Prices have yet to settle to pre-war levels.

The US Dollar, Japanese Yen and Canadian Dollar have correlations to crude prices, with the CAD and crude oil having a positive correlation and the USD and JPY having a negative correlation (USD less so than JPY).

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These instances have shown that political stability is a key ingredient which guides investment not just in currencies, but in the commodity markets as well.

Trade Scenarios

Political instability will invariably lead to economic instability, both of which are bad for the local currency.

A stable country politically is suitable for growth and foreign direct investment into the local currency and its stock market, all of which are good for the economy. Investment also boosts manufacturing, employment and consumer spending.

Countries will have their own individual political and economic situations. Try to understand the fundamentals regarding  a nation’s political situation when trying to trade with this indicator.

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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