Currencies: Undervalued versus Overvalued

By Farok Contractor, distinguished professor, Management & Global Business

Blog: Global Business - Economic & Cultural Commentaries

Currencies can be undervalued (very devalued) for natural reasons, such as political crises causing the rest of the world to become wary of holding that country’s assets or currency (e.g., Brazil and Turkey in the 2013–2019 period). Or in some cases, such as China, the government is alleged to deliberately keep the currency undervalued, for reasons described below.

Currencies can be overvalued (not sufficiently devalued) when foreigners in the rest of the world desire that currency in the exchange markets and wish to hold assets in that nation. Currencies can also be temporarily overvalued if the country’s central bank raises internal interest rates, and foreigners wishing to earn higher interest then demand that currency in the spot market. In other cases, especially in the emerging world, governments may deliberately keep their currency overvalued, for reasons described below.

Take the case of China, whose currency, the RMB (Renminbi yuan), is alleged to have been consistently undervalued by the People’s Bank of China (PBoC) since the early 1990s.

Advantages of Undervaluation

• Undervaluation gives a boost to China’s exporters because the dollars they earn convert into more RMB than they would otherwise.
• Undervaluation also makes foreign direct investment (FDI) more attractive to outside investors, since their currencies, say the U.S. dollar (USD), convert into more RMB with which to buy land, factories, or any local asset. The cost of establishing FDI in China is reduced, in say dollar terms, thereby boosting FDI in China from the rest of the world.
• The expectation of consistent future undervaluation by the PBoC has caused investment and jobs to pour into China’s export sector, turning it into the “Factory of the World.”
• Undervaluation makes imports coming into China more expensive in RMB, thereby protecting domestic Chinese firms from import competition and retaining investment and jobs in the country.
• Overall, an undervalued currency boosts investment and jobs – something critical in a population of 1.4 billion people.

Drawbacks of Undervaluation

• Effective protection against imports through undervaluation means reduced competition, which could also make local firms less competitive.
• In a country with a limited labor supply, the excess demand for jobs could escalate wages, which in turn could increase inflation in general. (This did not happen in China for many decades because of its large population. However, with the one-child policy finally having an effect starting in 2015, labor shortages are now being seen: Chinese labor costs have escalated sharply, threatening China’s “Factory of the World” position.)

Overvalued currencies are more likely to be found in emerging countries, for reasons described below. However, there are many examples of overvaluation in the rich world, such as Norway and Switzerland.

Advantages of Overvaluation:

• Overvaluation means that imports are cheaper in the local currency. This can be crucial for import-dependent populations or where basic necessities (e.g., food, medicines, energy) in emerging countries have to be imported for the local market.
• Overvaluation also increases political stability. To the extent that imports of basic necessities are handled or subsidized by the country’s government, the political consequences of allowing devaluation (i.e., reducing overvaluation) would be detrimental to the ruling regime. This is because – following a devaluation – basic necessities may still have to be imported anyway, costing more in the local currency. This may lead to protests against the government.
• In some cases, keeping a currency overvalued puts a damper on local inflation. Especially in import-dependent economies, importing at the overvalued exchange rate is cheaper than local production, keeping price increases under control.

Drawbacks of Overvaluation:

• Overvaluation may hurt or reduce exports because companies converting their foreign currency earnings (e.g., USD) at the overvalued exchange rate do not earn enough local currency (e.g., Rs ) to justify their costs. (See the companion post: Is the Indian Rupee Undervalued or Overvalued? What Purchasing Power Parity Theory Tells Us.)
• Overvaluation also means imports appear artificially cheap compared with local substitute products, thereby dampening investments and jobs in the sectors that could produce locally to compete against imports.
• FDI coming into a country with an over valuated currency is somewhat reduced because foreign currencies (e.g., USD) convert into fewer units of local currency (e.g., Rs) with which to buy assets such as land, factories, and so forth.

Photo illustration credit: Getty Images