Under-Valued Currency

Published Sep 8, 2024

Definition of Under-Valued Currency

An under-valued currency refers to a situation where the value of a country’s currency is lower than its true intrinsic value as determined by factors such as purchasing power parity (PPP), the balance of payments, and other economic indicators. This can happen either intentionally or unintentionally due to market forces. In many cases, governments may manipulate their currency’s value to gain a trade advantage by making their exports cheaper and imports more expensive.

Example

One of the most cited examples of under-valued currency is the Chinese Yuan (CNY). Throughout various periods, especially in the 2000s, China’s government has been accused of maintaining the Yuan at a lower value than its true worth. This strategy helped boost China’s export-driven economy by making Chinese goods cheaper on the international market, while simultaneously making imports into China more expensive. As a consequence, Chinese products became more competitive globally, helping to promote rapid industrial growth and accumulating large trade surpluses.

Why Under-Valued Currency Matters

Under-valued currency has far-reaching implications for both the country practicing such a policy and its trade partners. For the country with the under-valued currency, the primary benefit is an enhanced competitive advantage in international markets. However, this can also lead to trade imbalances, trigger inflationary pressures, and even cause retaliatory trade measures from other countries. On the other hand, importers in countries with overvalued currencies may suffer as their goods become pricier relative to those of countries with undervalued currencies. Hence, understanding under-valued currencies is crucial for policymakers, businesses, and investors engaged in the global marketplace.

Frequently Asked Questions (FAQ)

How is the value of a currency determined or identified as under-valued?

The value of a currency is typically evaluated through several economic models and empirical data. One commonly used measure is the Purchasing Power Parity (PPP), which compares the price levels of a fixed basket of goods between two countries. If a currency buys more goods domestically than it does abroad, it is considered under-valued. Additionally, Balance of Payments (BOP) data, interest rate differentials, and foreign exchange reserves are also analyzed to determine whether a currency is fairly valued, under-valued, or over-valued. Economists and financial analysts often consider a combination of these indicators to identify currency misalignments.

Are there any risks associated with maintaining an under-valued currency?

Yes, there are several risks associated with maintaining an under-valued currency. One major risk is the potential for inflation. By making exports cheaper, foreign demand for the country’s goods and services can increase, leading to higher production and, consequently, increased prices domestically. Additionally, an under-valued currency can prompt trade tensions and lead to punitive tariffs or sanctions from affected trade partners. Another risk is the accumulation of large foreign exchange reserves, which could be challenging to manage and may lead to financial imbalances. Moreover, reliance on artificial currency valuation could discourage necessary structural reforms within the economy.

Can an under-valued currency impact global trade balances?

Absolutely, an under-valued currency can significantly impact global trade balances. By making a country’s exports cheaper and more competitive on the global market, it can lead to a trade surplus for the country with the under-valued currency. Conversely, countries importing goods from such an economy may experience trade deficits as their more expensive exports struggle to compete. This imbalance can create tensions and may lead to calls for protectionist measures, which can destabilize the global trading system. Therefore, accurate currency valuation is critical for maintaining healthy international trade relationships and economic stability.

What tools do governments use to keep their currency under-valued?

Governments have several tools at their disposal to maintain an under-valued currency. One common method is through active intervention in foreign exchange markets, where the government or central bank buys foreign currencies to increase the supply of their own currency, thereby lowering its value. Another approach is maintaining low interest rates, which can make the currency less attractive to foreign investors. Additionally, implementing capital controls that restrict the flow of foreign funds can help retain an under-valued currency. Through these tools, governments can exert significant control over their currency’s valuation, albeit often with broader economic repercussions.