Exchange rate risk between Lek and Euro in the Albanian market

In broad terms, exchange rate risk [1] is major when a company or investment relies on a foreign currency that must be converted into the Albanian lek.

Foreign exchange risk can be caused by the appreciation/devaluation of the Lek, the appreciation/devaluation of foreign currency (Euro, Dollar, Pound, Franc), or a combination of both. It is a major risk to consider for exporters/importers and businesses trading in international markets.

How does the exchange rate affect the economy?

The exchange rate affects the real economy more directly through changes in the demand for exports and imports. A real depreciation of the Lek against the Euro makes exports more competitive abroad and imports less competitive domestically, thus increasing the demand for domestically produced goods. This moment is the regulatory part of the government in harmony with the Bank of Albania according to the tasks that they must perform respectively, to implement a stimulating and anti-dumping policy, in order not to have an economic situation that depends on the fate of imports.

Before managing the risk from currency exchange, it is necessary that the government and the Bank of Albania, as the two main columns that directly and indirectly affect the prevention of the consequences from speculative exchange risk, are known to manage the factors that affect the exchange rate

First, at present, changes in market inflation [2] cause variations in Euro exchange rates. Inflation differences in the EU and Albania are one of the weighty reasons why the Euro has different purchasing power and, as a result, different exchange rates during the year. As a result, countries with low inflation tend to have stronger currencies than those with higher inflation rates. Thus, during 2022, the lower inflation rate was one of the reasons why the value of the Lek usually remained high during the year.

Second, deviations in the interest rate announced by the Bank of Albania affect the value of the Lek and the conversion rate of the Euro with the Lek. Inflation [3] and the exchange rate are inextricably linked to interest rates. For example, setting higher interest rates gives the opportunity to absorb foreign capital, which seeks to earn at higher rates [4]. The result is that the country’s foreign exchange rate increases, making the Lek stronger. However, if these rates are kept too high for a long time, inflation will start to rise, resulting in the depreciation of the Lek, and this is a risk that should be quickly considered by the Supervisory Council of the Bank of Albania. This decision is particularly important in this historical period of financial market uncertainties as the change in interest rates affects the balance of gains and losses.

It may happen that despite the interest rate increase, inflation will not decrease as predicted, meaning that it will have less than expected effects on the exchange rate. Conversely, lowering interest rates tends to lower exchange rates. However, low inflation and high interest rates can attract foreign funds to the country, strengthening the exchange rate of the lek.

Thirdly, the parameters of the state’s budget balance directly affect the exchange rate. One of the most critical parameters is the deficit of the annual account of the state budget [5]. Based on the government’s political decision to engage in large-scale infrastructure projects since 2017, as well as knowing that it could not have all the funds for them, it has borrowed funds inside and outside the country (treasury bonds, bonds, and Eurobond etc.).

These projects have managed to stimulate the economy.

However, the increase in public debt, accumulated from the following years with a budget deficit, has had its impact on the increased inflation trend, which is not directly felt to a considerable extent, since the government directly controls (electricity prices) and indirectly other market prices. An argument that supports this submission is the fact that in recent years the government debt has grown a little faster than the economy, directly affecting inflation, but being neutralized precisely by informal money and the economy that dampens inflationary trends in the case of an economy that operates based on the free market and the rule of law.

A large public debt is a recipe for high inflation [6], i.e., the Lek is likely to be affected by its devaluation. Consequently, the income in foreign currency from exports has not been sufficient and this has dictated the exit to borrow from abroad to make up the difference, but also the acceptance of the necessary evil, the excessive circulation of informal money. Thus, on the one hand, starting from the high demand for Euros to pay the debt, this high demand has affected the exchange rate, exerting pressure to reduce the value of the Lek. On the other hand, the circulation of the Euro informally and unconcerned by the institutions to be restrained has increased the supply more than the demand for the Euro and has neutralized the impact of the high public debt in reducing the value of the Lek in the monetary exchange market.

Fourth, the trade balance (exports and imports) and payments have a direct impact on the exchange rate. A positive balance between exports and imports is also an indication that the economy is growing. While exporting, the country benefits from euros, from importing euros within the country get out of it, as an expense for the purchase of goods and services. If Albania’s exports were to grow at a higher rate than imports, this would be good news for the Lek exchange rate, as higher exports increase demand for the Lek, and therefore affect its value. to strengthen it.

In other words, if business conditions [7] are favorable, this will positively affect the exchange rate and vice versa. If the price of a country’s exports rises faster than its imports, its terms of trade have improved. The increase in terms of trade indicates the increase in demand for the country’s exports. The Lek will depreciate relative to its trading partners when exports grow at a slower rate than the price of imports.

A country’s current account reflects its trade balance and foreign investment income. The balance of payments changes the Lek exchange rate. The current account deficit and trade balance are inextricably linked. The trade balance is compared to that of trading partners in this scenario. If Albania’s current account deficit were more significant than that of a neighboring trading partner, it could weaken its currency. As a result, the Lek in this case would tend to be stronger. In the commercial reality of Albania with neighboring countries, it happens rarely and in small volumes, to influence the weight of this argument on the Lek exchange rate.

Economic growth increases the value of the Lek, leading to better exchange rates and vice versa. However, the contradictions of the indicators in the case of Albania do not make the argument complete and understandable in every case. For example, since Albania has recorded low unemployment in recent years, this means that citizens have more money to spend, which should help develop a stronger economy. But the citizens do not have that amount of money in their hands to support this economic logic. It’s worth noting that economic health is more of a catchphrase that includes several other factors such as interest rates, inflation, and the trade balance.

Fifth, political stability is related to the economy and therefore has an impact on the currency exchange rate. If the country’s political status is stable, investors will invest more and ultimately affect the country’s foreign exchange rate. On the other hand, weak political stability devalues ​​the Lek exchange rate.

Finally, the foreign exchange market is also influenced by the speculations of the operators of this market. Since the information in the foreign exchange market is not based on the stock exchange or other market instruments, businesses and citizens tend to demand more Euros, if its value tends to decrease, where as a result, the value of the Lek will increase and will affect the exchange rate. If speculators believe that the value of the Euro will rise in the future, they will demand a higher price now to profit. As a result of the increase in demand, the price will increase. As a result, changes in the exchange rate are often influenced by informal market attitudes rather than economic realities.

In closing, all these factors control foreign exchange rate variations.

Thus, we see that:

– weak political stability has devalued the Lek in relation to the Euro systematically over the years.

– the value of the Lek has a constant tendency to fall in relation to its trading partners, because exports grow at a slower rate than the price of imports.

– when the government’s debt grows faster than the economy, the consequence of this action should increase inflation by preventing more foreign investments from entering the country and by devaluing the Lek, but this, beyond the weak impact on the foreign exchange market, has not been visible to the public.

– the setting of higher interest rates during 2022 by the Bank of Albania has been able to attract a certain amount of foreign capital, also affecting the strengthening of the Lek against the Euro.

-keeping the inflation rate lower than the inflation rate of Albania’s trading partners has had an impact on the strengthening of the Lek.

– if the low GDP growth did not affect the strengthening of the Lek, at least it did not have an opposite effect.

– the influence of foreign exchange market speculators, the informality of the economy, as well as the large inflows of informal money (especially in recent years) from businesses and individuals who launder money has influenced the strengthening of the lek, as it has increased the supply in the foreign exchange market.

As a result of the combination of all the factors that control changes in the exchange rate have given the current effect on the market of a weaker Euro and will keep it at these levels as long as some of the main influencing factors for the evaluation of the Euro will not change their tendency.

[1] Exchange rate risk is the risk of monetary impact due to exchange rate fluctuations. Risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than that in which it is headquartered. For example, a company with its main location in Albania that does business in Kosovo, i.e. receives financial transactions in Euro and reports its financial statements in Lek is exposed to foreign exchange risk. Financial transactions, which are received in Euros, must be converted to Leka to be reported in the company’s financial statements. Changes in the exchange rate between the Euro (foreign currency) and Lek (domestic currency) would be the point of risk, which coincides with the term of foreign exchange risk.
[2] Inflation is the relative purchasing power of a currency compared to other currencies
[3] Bank of Albania use the interest rate to control inflation
[4] If a country has a high interest rate, lenders could earn more
[5] the difference between the budget’s expenditure and what it earns from the income it collects from taxes and subsidies
[6] Countries with large public debt may see their exchange rates depreciate because they are seen as unattractive investment destinations. This means the country has to pay more to service its debt
[7] compares export prices with import prices and relates to current accounts and balance of payments