A hard currency is one that's typically issued by a developed country, is traded worldwide and whose issuing country is deemed to be stable both in political and economic terms.
Those who invest in hard currencies do so because they, like those who invest in stocks and bonds, hope to capitalize on the fluctuation in the values of the assets they hold. To profit, the currency the investor purchases must increase in value, at which point they can sell it at a profit.
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Hard vs. Soft Currency
What is the difference between hard and soft currency?
Unlike soft currency, hard currency is stable, reliable, convertible and is widely accepted as a form of currency. Hard currencies are issued by countries that are economically and politically stable. With a hard currency, it's unlikely that the swings in the value of one currency will be drastic relative to that of another. The U.S. dollar, Canadian dollar and the Euro are hard currencies.
In contrast, soft currency is unstable, unreliable and not convertible and, as such, is not widely accepted as a form of exchange. What's more, soft currency experiences significant market fluctuations and its value depreciates sharply relative to the currency of other countries. Examples of soft currencies include the Venezuelan bolivar, the Zimbabwe dollar and the Syrian pound.
Some Factors Affecting a Currency's Status
Many factors determine whether a currency is a hard vs soft currency. One major factor is the level of corruption within the issuing country as well as the long-term stability of its purchasing power.
Interest Rates. Typically, the higher the interest rates, the higher the demand for the currency. The inverse is also true: the lower the interest rates, the lower the demand for a currency.
Inflation. In a growing economy, a rise in inflation will generally increase expectations that interest rates will rise as well, which will be interpreted by some investors that the demand for a currency will rise as well.
Economic Growth. A growing economy leads to more jobs and higher wages, which workers will use to buy more products, which will further stimulate the economy. Growth may lead to increasing inflation, which triggers expectations for interest rate increases. These factors, as well as foreign investment and increasing foreign demand, can boost an economy and its local currency.
A Country's Current Account Balance. A country's trade will positively influence a country's exchange rate when the demand for that country's goods is greater than that for the goods of other countries. In this case, the demand will be higher for the country's currency as well.
The Policies of a Country’s Issuing Central Bank. A central bank is in the position to take policy action that favorably affects its country's exchange rate, making exports more competitive, which is not evidence of currency manipulation. That requires a central bank to hold the value of the currency artificially below its true value.
Level of Corruption. The rampant corruption in a country contributes to a currency crisis because the corruption dissuades foreign investment in the country. Investors who are disposed to long-term investments in business will likely choose to not invest in a country where bureaucrats demand bribes or prey on businesses. As a consequence, the country may become dependent on bank loans to finance its growth.
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Effect of Soft Currency
A country with a soft currency is likely to experience hyperinflation and a low Gross Domestic Product (GDP). Also, it's likely that the currency has little value in foreign open markets. Consequently, it's difficult for the country's businesses to trade in international open markets.
Frequently, a country with a soft currency will peg its currency to a stable currency, such as the U.S. dollar, to gain a competitive trading advantage. A pegged or fixed exchange rate may help keep a country's exchange rate low, which has a positive effect on a country's exports.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.