Since the explosion of international trades and the success of capitalism in the last two centuries, international money flows have become very important. These flows are materialized as foreign investments and trades. At the international scale, the issue is that we deal with more than one currency (for example Euro and U.S. dollar) and the question of money valuation against another one appears. We will see that centrals banks around the world intervene in this process and play a key role. Let’s now explore how does valutation between different currencies works.
You may have heard in the media pieces of information such as the Euro rinforces against the U.S. dollar, but likely you do not see how does valuation and appreciation works. The answer is simple and dwell in a basic economic principle: the supply and demand.
Indeed, money itself follows the law of supply and demand. Let’s explore in detail how does this mechanism works throughout the example of the Euro/U.S. dollar valuation.
We compare two currencies by their exchange rate. In our case we denotes it by $/Euro. It represents the amount of U.S. dollar needed to purchase one euro. When this rate goes up, price of Euro goods increases, which implies that importation of European goods becomes more expensive, whereas the exportation by the U.S. becomes less expensive. Concerning investments, when the rate rises, holding Euro assets is better off, whereas holding U.S. dollar is worse off. So we can summarize as follow: when a currency is ‘weak’, it boosts exportation but reduces importation and foreign investments in the country. The contrary occurs when the currency is ‘strong’ (considering that a currency is said to be ‘weak’ or ‘strong’ always in comparison to another one).
Nevertheless, as the principle of supply and demand suggests it, the exchange rate tends normally to an equilibrium, because the effet of importation and foreign investments reinforces the currency.
Indeed, let’s take an example: when Americans buys some cheese to the French, the Americans pay the French in U.S. dollar. Then the French, who possess now U.S. dollar, naturally want to change this amount of money in Euro. So this process generates a demand for Euro. Result: the euro reinforces against the U.S. dollar. On the contrary, when the French buy cars to the Americans they pay them in euro. Tthe latter, willing U.S. dollar, create a demand for U.S dollar. Result: the U.S. dollar reinforces against the euro. This reasoning works exacty the same for the supply. Indeed, when the French receive U.S. dollar for the sale of cheese they create a supply of U.S. dollar, whereas Americans generate a supply of euro when they are paid for the sale of cars.
So imports and exports play a major role in the valuation of currencies. We could simply summarize this as follow. If a country exports more than it imports, its currency value increases, whereas if it imports more than it exports, its currency value decreases . A country with a ‘strong’ currency attractes foreign investments, whereas a country with a ‘weak’ currency tends to make investors go abroad. Nevertheless, currency value is as much important for investors the as its stability.
At the beginning, I said that central banks play a key role in this context. If you refer to the article about central banks, you may remember that central banks can act in diverse ways. Indeed, in the context of the U.S. dollar and the Fed, you may remember that the Fed can do open market operations and influence the federal funds rate and thus the interest rates that banks charge borrowers. if the Fed want to reinforces the U.S. dollar, it can try to increase the interest rates through the federal funds rate to attract investor and thus increase demand for U.S dollar. Or, it can do massive market operations such as purchase of its own currency to decreases supply of U.S. dollar. So, central banks play a role of regulation and stabilization of the currencies.
Now that you possess a better understanding of the subject, let’s give you two examplse:
– You may likely now that the Swiss National Bank (SNB) policy concerning the Swiss Franc (CHF) and the Euro has been to target the exchange rate CHF/EURO to 1.20 CHF. The goal beeing not to let the Swiss Franc becoming to strong against the Euro (sustain of Swiss exportation). So basically it has purchased massivly and daily euro to create an artificial demand for euro (I say artifical because the demand is not produced by the real economy).
– The second example is the Chinese policy for the Renminbi/Dollar exchange rate. You may know that the success of China is due to its massive production capacity but too to its ‘weak’ valued currency (you may have heard in the medias that the Chinese currency is undervalued, or that the Chinese currency is stuck to the U.S. dollar). Indeed, The Central Bank of China (CBC) actively contributes to the undervaluation of the Renminbi to sustain a high exportation. Its action is simple, it creates an artifical demand for the U.S dollar to maintain it high against the Renmibi. Indeed, the CBC issues Chinese currency and buys U.S. dollar with it. What happens then, is that by having a lot of U.S. dollars, the CBC buys U.S. bonds. This is why you may see important U.S. assets in the balance sheet of the CBC.
If you are interested in this issue, you may find of great interest the videos of Khan on KhanAcademy.
Introductory picture from: morguefile