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Investment - Value of Currencies
There are numerous elements that influence the value of a currency. The relative worth of a currency relies on the economic activity and outlook of a country. This section analyzes factors that determine the value of a currency and describes how to measure the relative value of currencies.
Major Factors That Affect the Value of a Currency
The key elements that determine the value of a currency include the country’s (1) balance of payments, (2) inflation, (3) interest rates, (4) government debt, and (5) the political and economic environment.
Balance of Payments
A current account deficit tends to lead to a devaluation of the home currency.
Level of Inflation
High inflation tends to lead to a devaluation of the indigenous currency.
Level of Interest Rates
High interest rates tend to lead to an appreciation of the home currency.
Level of Government Debt
High government debt tends to lead to a depreciation of the domestic currency
Political and Economic Environment
Political instability and bad economic prospects tend to lead to a depreciation of the domestic currency.
Balance of Payments
As noted, the current account balance has an impact on the value of a currency. In a floating exchange rate system, the exchange rate should adjust to remedy an unsustainable current account deficit or surplus.
If a country has a big current account deficit, the domestic currency should devalue relative to foreign currencies. The relative price of that country’s exports in international markets should reduce, making exports more competitive.
At the same time, the relative price of imports in the country should rise, making imports more expensive. Exporting more and importing less should in principle lower the current account deficit and could even transform it into a surplus. In contrast, if a country has a high current account surplus, the native currency should gain relative to foreign currencies. The home currency’s appreciation, or getting stronger compared to the foreign currency, should have a negative influence on exports and a positive effect on imports, diminishing the current account surplus.
A floating exchange rate system tends to be self-adjusting. But the self-adjusting method does not always operate in practice since factors besides international commerce influence exchange rates. In addition, the natural correction that should lead to a reduction of the current account deficit or surplus may not occur if the country belongs to a single currency zone, such as the European Union (EU). France, Belgium, and Italy run huge current account deficits, although the euro is used by other EU members that might have current account surpluses. It is difficult, if not impossible, for natural corrections to take place if the countries in question utilize the same currency but confront extremely different economic situations.
Level of Inflation
Inflation erodes the purchasing power of a country’s currency, so when prices climb, a unit of domestic currency buys less international products and services.
The following example illustrates the effect of inflation on the purchasing power of a country’s currency.
Example: Effect of Inflation on a Country’s Currency
Consider the pricing of similar loaves of bread in Ireland and in the United Kingdom in January and in June.
In January, the loaf of bread costs EUR1.20 in Ireland and GBP1.00 in the United Kingdom, which implies an exchange rate of EUR1.20/GBP1. If inflation in the United Kingdom raises the price of the bread to GBP1.10 in June, but the price remains EUR1.20 in Ireland, then the purchasing power of the pound is lower in June than it was in January. The exchange rate has increased from EUR1.20/GBP1 to EUR1.20/GBP1.10, or EUR1.09/GBP1. Because a pound now buys fewer euros, it has depreciated relative to the euro.
A country with a consistently high level of inflation will see the value of its currency diminish relative to the currency of a country that has a consistently low level of inflation.
Level of Interest Rates
Higher interest rates, unless they are driven by inflation, normally enhance capital flows into a country since they make investments in that country more attractive, all other circumstances being equal. Increased investments in the country create a demand for the country’s currency. Thus, higher interest rates push the value of the currency higher.
Increasing interest rates is a technique for central banks to control inflation. When a central bank boosts interest rates, it may entice more foreign investors to buy that currency, making the currency gain. The strengthening currency makes imports less expensive and helps lower inflation.
Some countries that have balanced economic development and higher relative interest rates may see increasing interest in their currency. This increase occurs because many investors regard rising interest rates as a way of earning a higher yield, so they buy the currency to partake in that yield. But high interest rates can also decrease capital inflows if investors believe they lead to rising inflation and currency devaluation.
Level of Government Debt
If it looks that a government is functioning with too much debt and may be unable to fulfill a promised payment of interest or principal, investors may decide that they no longer wish to retain the bonds issued by that country.
If investors sell the government bonds they own and take their money out of the country, it will trigger a depreciation of the country’s currency.
" " Political and Economic Environment
Capital tends to flow to countries with political stability and excellent economic performance. Countries with political instability or poor economic prospects, such as low growth and high unemployment, are likely to see the value of their currencies drop.
As an economy grows, capital flows will also often increase. Government policies towards international investors will also effect capital flows.
Foreign direct investments (FDIs)
Capital flows normally increase when a country becomes more open to outside investors and liberalises foreign direct investments (FDIs), the investments made by foreign investors and companies.
Reserve currency
A reserve currency is a currency that is held in considerable amounts by governments and financial organizations as part of their foreign exchange reserves.
A reserve currency tends to be what globally traded items are priced in, including commodities, such as oil and gold. Because the US dollar is a reserve currency, the demand for US financial assets and for US dollars is stronger than it would be based on the country’s macroeconomic outlook alone.
Relative Strength of Currencies
The idea of purchasing power parity has long been used to explain relative currency valuations.
Purchasing power parity is an economic theory based on the premise that a basket of commodities in two different countries should cost the same, after taking into account the exchange rate between the two countries’ currencies.
Purchasing power parity is the premise underpinning the Economist’s Big Mac index. On a regular basis, the Economist records the price of McDonald’s Big Mac hamburgers in various nations across the world, and then it estimates what the exchange rates should be to make the price of Big Macs the same in all the countries.
This exchange rate relies on buying power parity and assumes that an identical product, the Big Mac, should have the same price everywhere on Earth. The Economist evaluates the purchasing power parity exchange rates compared to the US dollar and compares them with the actual exchange rates to assess if currencies are under- or overvalued relative to the US dollar.
In June 2022, a Big Mac cost USD5.15 in the United States and ZAR39.90 in South Africa, which implies a purchasing power parity exchange rate of ZAR7.75/USD1 (ZAR39.90/USD5.15). Suppose the real exchange rate was ZAR17.04/USD1. This means, based on purchasing power parity, the South African rand is undervalued relative to the US dollar since it takes more South African rand than buying power parity implies to acquire a US dollar.
Put another way, if a Big Mac cost ZAR39.90 in South Africa and the real currency rate was ZAR17.04/USD1, the cost of a Big Mac in the United States should be USD2.34. But the actual cost is USD5.15, which suggests that the South African rand was devalued by more than 50%. In other words, changing ZAR39.90 to US dollars would only provide USD2.34, which is not enough to buy a Big Mac in the United States.
The purchasing power parity exchange rates created using Big Macs are only roughly indicative of actual exchange rates because they are based on just one product. In truth, purchasing power parity exchange rates should reflect a representative basket of products, but the Big Mac index serves as a readily accessible proxy.
Although buying power parity provides a mechanism to explain comparable currency valuations, it has drawbacks. Two of these constraints are the difficulty of establishing a basket of items for comparison between countries and the impediments to international trade.
These factors help explain why data suggests that purchasing power parity does not persist very well in the short to medium term. But in the long term, aberrations of actual exchange rates from purchasing power parity rates gradually fix themselves. In other words, buying power parity tends to apply only in the long term.
There are numerous elements that influence the value of a currency. The relative worth of a currency relies on the economic activity and outlook of a country. This section analyzes factors that determine the value of a currency and describes how to measure the relative value of currencies.
Major Factors That Affect the Value of a Currency
The key elements that determine the value of a currency include the country’s (1) balance of payments, (2) inflation, (3) interest rates, (4) government debt, and (5) the political and economic environment.
Balance of Payments
A current account deficit tends to lead to a devaluation of the home currency.
Level of Inflation
High inflation tends to lead to a devaluation of the indigenous currency.
Level of Interest Rates
High interest rates tend to lead to an appreciation of the home currency.
Level of Government Debt
High government debt tends to lead to a depreciation of the domestic currency
Political and Economic Environment
Political instability and bad economic prospects tend to lead to a depreciation of the domestic currency.
Balance of Payments
As noted, the current account balance has an impact on the value of a currency. In a floating exchange rate system, the exchange rate should adjust to remedy an unsustainable current account deficit or surplus.
If a country has a big current account deficit, the domestic currency should devalue relative to foreign currencies. The relative price of that country’s exports in international markets should reduce, making exports more competitive.
At the same time, the relative price of imports in the country should rise, making imports more expensive. Exporting more and importing less should in principle lower the current account deficit and could even transform it into a surplus. In contrast, if a country has a high current account surplus, the native currency should gain relative to foreign currencies. The home currency’s appreciation, or getting stronger compared to the foreign currency, should have a negative influence on exports and a positive effect on imports, diminishing the current account surplus.
A floating exchange rate system tends to be self-adjusting. But the self-adjusting method does not always operate in practice since factors besides international commerce influence exchange rates. In addition, the natural correction that should lead to a reduction of the current account deficit or surplus may not occur if the country belongs to a single currency zone, such as the European Union (EU). France, Belgium, and Italy run huge current account deficits, although the euro is used by other EU members that might have current account surpluses. It is difficult, if not impossible, for natural corrections to take place if the countries in question utilize the same currency but confront extremely different economic situations.
Level of Inflation
Inflation erodes the purchasing power of a country’s currency, so when prices climb, a unit of domestic currency buys less international products and services.
The following example illustrates the effect of inflation on the purchasing power of a country’s currency.
Example: Effect of Inflation on a Country’s Currency
Consider the pricing of similar loaves of bread in Ireland and in the United Kingdom in January and in June.
In January, the loaf of bread costs EUR1.20 in Ireland and GBP1.00 in the United Kingdom, which implies an exchange rate of EUR1.20/GBP1. If inflation in the United Kingdom raises the price of the bread to GBP1.10 in June, but the price remains EUR1.20 in Ireland, then the purchasing power of the pound is lower in June than it was in January. The exchange rate has increased from EUR1.20/GBP1 to EUR1.20/GBP1.10, or EUR1.09/GBP1. Because a pound now buys fewer euros, it has depreciated relative to the euro.
A country with a consistently high level of inflation will see the value of its currency diminish relative to the currency of a country that has a consistently low level of inflation.
Level of Interest Rates
Higher interest rates, unless they are driven by inflation, normally enhance capital flows into a country since they make investments in that country more attractive, all other circumstances being equal. Increased investments in the country create a demand for the country’s currency. Thus, higher interest rates push the value of the currency higher.
Increasing interest rates is a technique for central banks to control inflation. When a central bank boosts interest rates, it may entice more foreign investors to buy that currency, making the currency gain. The strengthening currency makes imports less expensive and helps lower inflation.
Some countries that have balanced economic development and higher relative interest rates may see increasing interest in their currency. This increase occurs because many investors regard rising interest rates as a way of earning a higher yield, so they buy the currency to partake in that yield. But high interest rates can also decrease capital inflows if investors believe they lead to rising inflation and currency devaluation.
Level of Government Debt
If it looks that a government is functioning with too much debt and may be unable to fulfill a promised payment of interest or principal, investors may decide that they no longer wish to retain the bonds issued by that country.
If investors sell the government bonds they own and take their money out of the country, it will trigger a depreciation of the country’s currency.
" " Political and Economic Environment
Capital tends to flow to countries with political stability and excellent economic performance. Countries with political instability or poor economic prospects, such as low growth and high unemployment, are likely to see the value of their currencies drop.
As an economy grows, capital flows will also often increase. Government policies towards international investors will also effect capital flows.
Foreign direct investments (FDIs)
Capital flows normally increase when a country becomes more open to outside investors and liberalises foreign direct investments (FDIs), the investments made by foreign investors and companies.
Reserve currency
A reserve currency is a currency that is held in considerable amounts by governments and financial organizations as part of their foreign exchange reserves.
A reserve currency tends to be what globally traded items are priced in, including commodities, such as oil and gold. Because the US dollar is a reserve currency, the demand for US financial assets and for US dollars is stronger than it would be based on the country’s macroeconomic outlook alone.
Relative Strength of Currencies
The idea of purchasing power parity has long been used to explain relative currency valuations.
Purchasing power parity is an economic theory based on the premise that a basket of commodities in two different countries should cost the same, after taking into account the exchange rate between the two countries’ currencies.
Purchasing power parity is the premise underpinning the Economist’s Big Mac index. On a regular basis, the Economist records the price of McDonald’s Big Mac hamburgers in various nations across the world, and then it estimates what the exchange rates should be to make the price of Big Macs the same in all the countries.
This exchange rate relies on buying power parity and assumes that an identical product, the Big Mac, should have the same price everywhere on Earth. The Economist evaluates the purchasing power parity exchange rates compared to the US dollar and compares them with the actual exchange rates to assess if currencies are under- or overvalued relative to the US dollar.
In June 2022, a Big Mac cost USD5.15 in the United States and ZAR39.90 in South Africa, which implies a purchasing power parity exchange rate of ZAR7.75/USD1 (ZAR39.90/USD5.15). Suppose the real exchange rate was ZAR17.04/USD1. This means, based on purchasing power parity, the South African rand is undervalued relative to the US dollar since it takes more South African rand than buying power parity implies to acquire a US dollar.
Put another way, if a Big Mac cost ZAR39.90 in South Africa and the real currency rate was ZAR17.04/USD1, the cost of a Big Mac in the United States should be USD2.34. But the actual cost is USD5.15, which suggests that the South African rand was devalued by more than 50%. In other words, changing ZAR39.90 to US dollars would only provide USD2.34, which is not enough to buy a Big Mac in the United States.
The purchasing power parity exchange rates created using Big Macs are only roughly indicative of actual exchange rates because they are based on just one product. In truth, purchasing power parity exchange rates should reflect a representative basket of products, but the Big Mac index serves as a readily accessible proxy.
Although buying power parity provides a mechanism to explain comparable currency valuations, it has drawbacks. Two of these constraints are the difficulty of establishing a basket of items for comparison between countries and the impediments to international trade.
These factors help explain why data suggests that purchasing power parity does not persist very well in the short to medium term. But in the long term, aberrations of actual exchange rates from purchasing power parity rates gradually fix themselves. In other words, buying power parity tends to apply only in the long term.
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