What makes currencies strong or weak?


The pound has weakened markedly against the euro and dollar in recent months - but many commentators believe this is an overdue correction to an overvalued currency. So what determines a currency's exchange rate, and why are currencies sometimes deemed to be over or undervalued?

Currency, Sterling, US Dollar, and The Euro

A currency's exchange rate is its price in terms of another currency. Most major currencies – the pound, dollar, euro and yen for instance – are 'freely floating'. This means their exchange rate is determined by market forces, by the levels of supply and demand on the international markets.

So what factors affect this?

Interest rates
A higher interest rate means a better return on bonds, gilts and other Government securities and will, therefore, tend to attract financial capital from overseas. Sterling must be purchased in order to buy these assets. So, if UK interest rates go up – or more importantly, are expected to go up – the pound will tend to strengthen against other currencies, and vice versa.


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Economic health
Institutions tend to move investments out of weakening economies and into ones perceived to be strengthening. So an economy whose indicators (like growth, inflation and debt burden) are positive tends to see more demand for its currency and see its exchange rate strengthen.

The pound has generally seen itself rated strongly against both the dollar and the euro in recent years, as its economy has done relatively well.

Foreign trade
Other countries must buy sterling in order to buy UK goods, so if there is a high demand for British exports (relative to our demand for foreign imports), the pound will tend to strengthen. Large trade deficits – as the UK has run in recent years – will tend to depress a currency. But it is a circular relationship: the exchange rate will also affect levels of imports and exports. If the pound is strong, UK exports become less attractive, and foreign imports more so.

Official interventions
Governments or central banks could intervene to prop up a currency – for political or economic reasons - by buying it on the international markets, or by raising interest rates. The John Major government in 1992 controversially raised interest rates by five percentage points and spent billions in a doomed attempt to keep sterling in the European exchange rate mechanism (ERM).

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Markets don't like unexpected news and because currency markets are very 'liquid' (shortages of a currency are very rare), exchange rates are prone to move quickly in response to surprises. Currencies are also traded as speculative investments in their own right, and expert brokers trade them according to how they think the market will move. But these trades in themselves will, of course, affect exchange rates.

So when and why is a currency described as weak or strong?

This is the tricky one. After all, one could argue that the market price is the right price, and therefore it's never too high or too low. But markets aren't perfect.

Exchange rates are sometimes perceived as being unrealistically high or low. For instance, it is widely asserted that sterling has in recent years been strong (or 'overvalued') against the dollar, and perhaps even the euro.

Much of this is intuitive: if US goods seem unnaturally cheap, and US importers shun UK goods as too expensive, and the British trade deficit is widening, then the suspicion arises that the pound is too strong.

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Can a sort of 'average rate' be discerned over the long-term? Not really: changes in countries' real economic conditions mean that an historical 'fair value' for the pound against the dollar doesn't really exist. Sterling nearly hit the $1 dollar mark in 1985, but had been as high as $2.44 five years previously.

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That doesn't mean however that a fair value can't be estimated at any one time, or over the medium term. The best-known method of measuring what it might be is purchasing power parity (PPP).

This takes as its basis the cost of living, and asks: what is the exchange rate that would make one's money go exactly as far in one country as the other?

The most basic versions are the measures that use one product. For instance, a 4GB iPod Nano costs £99 in the UK and $149 in the US - direct from the Apple Store in both cases. This makes the PPP exchange rate just over $1.50 to the pound.

The Economist magazine runs its Big Mac index, which surveys the price of the burger around the world. In 2007, a Big Mac was priced at £1.99 in the UK, and $4.01 in the US: this means the PPP exchange rate is $1.71.

Obviously, these are slightly unscientific measures. There could be specific local reasons why iPods or Big Macs are priced differently, and most people's cost of living is not restricted to consumer electronics and fast food.

So more advanced PPP measures take a basket of goods and looks at how much it costs in the US in dollars versus how much it costs in the UK in pounds. The World Bank undertakes this laborious process for every country in the world in its International Comparison Program.

In 2006, its report put the PPP exchange rate at $1.66 to the pound.

So in this sense the feeling that sterling has in recent years been overvalued against the dollar is justified.

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What factors influence exchange rates and make a currency strong or weak?


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