Undervalued currency

3 key takeaways

• An undervalued currency is priced lower than its true market value, often making a country’s exports cheaper and more competitive.
• It can result from government intervention, economic conditions, or market perceptions.
• While beneficial for exporters, an undervalued currency can lead to trade imbalances and inflationary pressures.

What is an undervalued currency?

An undervalued currency is a currency that is trading below its perceived fair market value. The fair market value of a currency is typically determined by factors such as purchasing power parity (PPP), interest rates, economic performance, and investor perceptions. When a currency is undervalued, it means that it costs less than what is considered its true value based on these fundamentals.

Causes of currency undervaluation

Several factors can contribute to the undervaluation of a currency:

• Government intervention: Governments or central banks may deliberately undervalue their currency by setting lower exchange rates or through monetary policies such as foreign exchange interventions. This is often done to boost exports by making them cheaper on the global market.
• Economic fundamentals: Weak economic indicators, such as low interest rates, high inflation, or poor economic growth, can lead to a lower currency value as investors seek more stable investments elsewhere.
• Market perceptions: Investor sentiment and speculative activities can influence currency values. If investors believe a currency is overvalued, they may sell it, leading to a decrease in its value.

Implications of an undervalued currency

An undervalued currency has several significant implications for a country’s economy:

• Boosts exports: By making goods and services cheaper on the international market, an undervalued currency can increase a country’s exports. This can help stimulate economic growth and create jobs in export-oriented industries.
• Trade imbalances: While boosting exports, an undervalued currency can also lead to trade imbalances. Countries with undervalued currencies often experience large trade surpluses, which can create tensions with trading partners and lead to retaliatory trade measures.
• Inflationary pressures: An undervalued currency can lead to higher import prices, contributing to domestic inflation. As the cost of imported goods rises, consumers and businesses face higher expenses.
• Capital flows: An undervalued currency can attract foreign investment in certain sectors, particularly in industries focused on exports. However, it may also deter investment in sectors reliant on imports or that do not benefit from the currency’s undervaluation.

Examples of undervalued currencies

Historical and contemporary examples of undervalued currencies include:

• Chinese yuan (CNY): For many years, China was accused of keeping the yuan undervalued to boost its export competitiveness. Although the yuan has appreciated in recent years, debates continue over its true market value.
• Swiss franc (CHF): The Swiss National Bank has occasionally intervened to prevent excessive appreciation of the franc, aiming to keep it at a level supportive of the Swiss economy’s export sector.

Measuring currency undervaluation

Several methods are used to assess whether a currency is undervalued:

• Purchasing Power Parity (PPP): PPP compares the relative prices of a standard basket of goods between two countries. If a currency buys more of the basket in one country than another, it may be undervalued.
• Real Effective Exchange Rate (REER): REER adjusts the nominal exchange rate by comparing relative price or cost levels across countries, providing a more comprehensive measure of a currency’s value.
• Big Mac Index: An informal measure created by The Economist, the Big Mac Index compares the price of a Big Mac burger in various countries. Significant differences in prices can indicate whether a currency is overvalued or undervalued relative to the US dollar.

Understanding the concept of an undervalued currency is crucial for analyzing international trade dynamics, economic policies, and global financial markets. For further exploration, topics such as exchange rate mechanisms, monetary policy, and international trade relations provide deeper insights into the causes and effects of currency valuation.