- Education and Science»
Is a Strong Currency Good or Bad?
Is a strong currency good or bad?
Sounds like a very silly question, right? A strong country is better than a weak country; a strong body constitution better than a weak one. So it must follow that a strong currency is better than a weak currency.
But what is a strong currency? A strong currency is one which is worth more, when compared to another currency, e.g.:
1 Euro = 1.29 US Dollar
Therefore, the euro is stronger than the U.S. dollar. A strong currency enables us to buy more goods and services with the same amount of money. However, this advantage is usually not felt for goods and services derived entirely from within the country. Yet, just because a particular product is manufactured within the country doesn’t mean that it also originates entirely from that country. Some components are likely to originate from foreign countries. Even in agriculture, fertilizers and pesticides may be imported. A strong currency therefore benefits domestic consumers because it allows them to buy more imported goods and services and may even help them afford more domestic goods and services.
Needless to say, a weak currency has less purchasing power. So why would any country want a weak currency? The truth, however, is just the exact opposite. Most countries, if given a choice, would actually opt for a weaker, rather than a stronger currency. Sounds absurd, right?
US and China Compete with Each Other for Weak Currency to Boost Exports
A Strong Currency is Bad and a Weak Currency is Good are Nonsense! (A counter-argument)
It does make sense
Let's take the case of trade between United States and China.
Scenario 1: China as a net exporter
China imports organic chemicals from America and exports power generation equipment. Let's say that in a year, China only imports 100 tons of organic chemicals at US$200 per ton from America and exports 100 power generation equipment at US$500 each.
Assuming the exchange rate is US$1 = 6 renminbi:
100 tons of organic chemicals will cost China 120,000 renminbi, while 100 power generation equipment will bring in export revenues of 300,000 renminbi. The trade surplus is 180,000 renminbi.
Supposing China strengthens its currency to: US$1 = 5 renminbi:
100 tons of organic chemicals will now cost China 100,000 renminbi, while 100 power generation equipment will bring in export revenues of 250,000 renminbi. The trade surplus is now reduced to 150,000 renminbi.
Thus, it is obvious that a strong currency is detrimental to China's trade surplus. (A trade surplus is very much a person's income less expenses.) Trade surpluses increase the wealth of a nation, just like savings increase an individual's net worth. However, the above scenario is only true if China is a net exporting country, as can be seen from the following contrasting example.
Scenario 2: China as a net importer
Now let's see what happens, if China is a net importing country, where it imports 1,000 tons of organic chemicals a year at US$200 per ton from America and exports 100 power generation equipment at US$500.
At US$1 = 6 renminbi, 1,000 tons of organic chemicals will cost China 1,200,000 renminbi, while 100 power generation equipment will bring in export revenues of 300,000 renminbi. The trade deficit is 900,000 renminbi.
If China weakens its currency to US$1 = 7 renminbi, 1,000 tons of organic chemicals will now cost China 1,400,000 renminbi, while 100 power generation equipment will bring in export revenues of 350,000 renminbi. The trade deficit has now increased to 1,050,000 renminbi. Thus, in general, a strong currency is more beneficial to a net importing country.
Some countries deliberately keep their currencies undervalued, so as to make their exports less expensive, but this is usually an unsustainable policy. Had it been otherwise, countries will be tempted to devalue their currencies by as much as possible. A devaluation usually has a destabilizing effect on the economy. For one, it would hit domestic companies with foreign loans and may bring about a wave of insolvencies, as these companies would now have to pay more in return for what they had borrowed earlier.
What are the effects of changes in the exchange rates?
A change in the exchange rate of a country's currency can either enhance or reduce the competitiveness of its goods abroad and, hence, its demand. When the U.S. dollar, say, strengthens or gains in value, importing countries have to pay more for the U.S. dollar to buy U.S. produce. This increases the price of U.S. goods for importing countries, resulting in a drop in demand and reduces total overall profits for U.S. businesses. On the other hand, U.S. businesses and consumers can now buy foreign goods and services at a lower price.
On the other hand, when the U.S. dollar weakens in value, it has an opposite effect. A weak currency helps to stimulate exports because it decreases the price of its goods to importing countries. When a country produces more goods and services, the economy will grow: More sales equal more jobs, and more jobs equals more employment which equals more people with money. More people with money equals more spending and more spending equals even more jobs. This is "economic growth", a cycle of increasing employment opportunities and long-run growth in production and consumption of goods and services.
A weakened dollar, however, also means that U.S. importers must now pay more for foreign goods, resulting in a reduction in the U.S. demand for such goods. Under such circumstances, locally-produced goods and commodities would become more competitive, as compared to the now more expensive foreign goods.
In short, a strong currency encourages imports and discourages exports.
What determines currency exchange rates?
Market forces: If a country, say the United States, is exporting a lot of goods and services abroad, foreign buyers will demand more U.S. dollars in the foreign exchange markets to pay the bills. When the demand for dollars goes up, its price in the market will rise because the amount of dollars in circulation is pretty well fixed over the medium term.
The demand for the U.S. dollar could also be due to:
- foreigners intending to invest in the United States, be it to speculate in the stock market or else to invest in real estate properties; or
- foreigner repaying debts owed to the United States.
Factors that increase the supply of a country's currency or else decrease its demand, on the other hand, tend to cause the currency exchange rate to lose in value. Such factors include the desire of domestic consumers and businesses to buy imported goods and services, or to invest or repay debts owed outside the country.
Apart from the market forces of supply and demand for the currency, the currency exchange rate is also determined by a wide range of other factors:
- government policies;
- economic fundamentals such as:
- current account deficits;
- public debt;
- terms of trade;
- interest rates; and
- imported inflation;
- political stability and economic performance.
Governments can influence exchange rates:
- directly, by pegging their currency to the U.S. dollar; or
- indirectly, by manipulating the amount of money in circulation via interest rates, or by purchasing other currencies on the foreign exchange markets.
When faced with a sharp decline in currency value, the government may increase interest rates in order to control inflation. This would, in turn, increase the cost of capital, causing harm to the business community. Up to a point, a weak currency is beneficial to exporters, beyond which, however, it can turn bad.
Governments can also strengthen a currency by implementing or maintaining tight monetary policies, also known as contractionary monetary policies. Tight monetary policies, remove money and credit from a country’s money supply, thereby increasing its exchange rate via the law of supply and demand.
When the government adopts a hands-off approach by allowing its exchange rate to fluctuate against other currencies via the market forces of supply and demand, the currrency is termed as a "floating currency".
Why do some net exporting countries want a strong currency?
In September 2006, the U.S. House of Representatives passed the Schumer-Graham bill, calling for a tariff of 27.5% to be imposed on China’s exports, in an attempt to force China to strengthen the value of its currency. (The legislation was subsequently withdrawn, after a personal appeal by President George W. Bush.) The 27.5% figure was arrived at, based on what was cited to be the undervaluation of the renminbi. The US trade deficit with China had then stood at US$9.9 billion. At the same time however, China was recording an overall trade deficit of US$7.22 billion, the largest in at least 6 years, due to large deficits with commodity exporters and Asian countries. Hence, its reluctance to do so.
Yet, instead of forcing China to strengthen the value of its currency, why can't the United States devalue its own currency unilaterally? Won't that be easier?
AdventuresinCapitalism says that, other than net importing countries preferring a strong currency in order to buy cheaper products, a strong currency "gets you political power. It lets you dictate the terms of trade and the terms of foreign aid that you dispense. You can subsidize your allies with a strong currency and you can bring enemies into your circle of influence with it. A strong currency is the ultimate tool of the country with expansionary political goals..."
At one time, resource-rich countries also aspired to have a strong currency so that they could buy imported goods more cheaply with their export earnings. However, ever since the Dutch economic crisis of the 1960s (also known as the Dutch Disease), following the discovery of North Sea natural gas, most resource-rich countries are now worried that a strong currency could harm their domestic industries. Thus, to protect domestic industries, the oil-rich Middle Eastern countries are pegging their currencies to the U.S. dollar. Chile and Peru, on the other hand, are accumulating foreign reserves to prevent their currencies from appreciating (via a reduction in the supply of their own currency in circulation).
- Results in cheaper imported goods, thus exerting a downward pressure on imported inflation;
- Forces domestic producers to improve their efficiency in order to compete in the international market.
- Makes exports uncompetitive in the international market, thus hurting export industries;
- Aggravates unemployment problems;
- Induces consumers to buy more imported goods, thereby:
- hurting domestic industries; and
- causing higher currency outflow.
- Makes exports cheaper, resulting in:
- higher export volume and lower production costs, due to economy of scale;
- improved balance of trade; and
- higher employment level;
- Discourages consumers from buying imported goods, thereby:
- benefiting domestic industries; and
- resulting in lower currency outflow.
- Causes imported inflation, i.e. products using imported content will become expensive, thus affecting general price levels.
Currency undervaluation has been said to be a “beggar-thy-neighbor” policy because it:
- improves domestic trade balance; and
- adversely affects the trade balances of other countries.
Conversely, currency overvaluation is said to be a “beggar-thyself” policy.