How to make sense of changes in exchange rates?
And thoughts on exchange rates in general…
In order to answer the above question, we need to see how exchange rates are initially set when two countries trade with one another. Let’s imagine we have two countries, country A and country B, and they both make only two products, namely apples and oranges. In country A it takes 1 hour of labor to produce an apple and 2 hours of labor to produce an orange. In country B it takes 2 hours of labor to produce an apple and 6 hours of labor to produce an orange. Right off the bat we know that country A has higher productivity and is thus more advanced. We can also see that in country A the price of an orange equals that of two apples, while in country B the price of an orange is three apples. Therefore the relative cost of apples is cheaper in country B while the relative cost of oranges is cheaper in country A.
Given the lower relative cost of apples in country B, it becomes attractive for country A to import apples from country B instead of producing it at home. Therefore those that were producing apples in country A switch to producing oranges, and use those oranges to import apples from country B. Those that were producing oranges in country B in turn now switch to producing apples since country A can provide them with oranges. The apples can be bought at the prevailing price in country B (i.e. three apples per orange), that is unless country A’s apple consumption is such that country B would need to cut back on its own apple consumption to meet it. If this is the case, in order to be convinced to do so country A would have to offer more oranges in return for each apple. Therefore price of apples relative to oranges ultimately rises to the point such that country A’s need for apples can be met, or where it is no longer cheaper for country A to import apples from country B.
We can see here that trading with country B lowers the cost of apples in country A. As a result the number of apples sold in country A goes up as a result of trade, to the point where the ROI of selling oranges and importing apples there is equal. Therefore we must take note that trade lowering the cost of apples for country A impacts its consumption mix by increasing the proportion of apples consumed to oranges. This upward force on consumption of apples then also impacts the exchange rate, as it means country A demands more apples from country B.
Thus far, seeing how exchange rates are set we can conclude that when two countries engage in trade, the cost of production for both countries goes down. In relative terms however the impact is greater for the smaller of the two countries (in terms of economic output). Therefore we can also say that if one country is growing more rapidly relative to another, then its currency must gradually weaken against that of the other.
What has been said here so far doesn’t completely explain how exchange rates are set. One other force, namely cross-border investments, also significantly impacts exchange rates.
The first question that can come to mind here is why are cross-border investments made in the first place? Why does an owner of capital in country A decide to move their capital into country B? Cross-border investments are always made in search of superior returns. Next, we can ask why investment returns in two countries would be different? The answer lies in the fact that the cost of resources (such as labor) in less developed countries is lower, and this can mean higher available returns when compared to developed countries.
Continuing with our example from earlier, if capital moves from country A to country B it results in the price of apples relative to oranges becoming more expensive. This is because the production from country A is oranges (or primarily oranges compared to country B) and so as this capital moves to country B it increases the proportion of oranges to apples there and so pushes down price of oranges relative to apples. Therefore this is how we can see that investment flowing into a country strengthens its exchange rate. If the flow of investments into a country slows down however or reverses, then the exchange rate will have to come down accordingly. This will happen if expected returns in a country go down, which may be due to cost of resources there going up or an economic contraction (for example because of a credit crisis or a supply-side shock).
In the case of economic contractions, an important point (which pertains to exchange rate movements) is that they are accompanied by contractions of credit, which in turn sends the price of cash (i.e. the interest rate) up. If in the face of receding credit, the Central Bank does not intervene and inject liquidity, the exchange rate strengthens, because asset yields go up in accordance with the yield on cash. By providing liquidity however the Central Bank can prevent interest rates from going up and can actually lower them, which in turn lowers the exchange rate. With a lower exchange rate domestic resources become more competitive globally, which makes the country more attractive for investments. It is worth noting here that the price of a country’s resources (such as labor) in terms of foreign currency is a great way of determining if a currency is relatively overpriced or underpriced.
Further observations related to exchange rates (unique cases)
- If a country is a commodity producer where the relative cost of the commodity is lower at home than abroad, then trading with other countries clearly reduces the cost of production for this country (similar to our apples and oranges example earlier) and accordingly improves return on capital. If the price of the commodity in global markets goes down however, then the benefits would be reversed and cost of production in the country would go back up. In such a case there would be a lot of disruption felt in the economy also.
- In keeping with the above example, if the commodity in question is limited in nature such that those that produce it find themselves in a protected monopoly situation, then international trade may not have a positive impact for local investors. Due to cheap imports supply of goods go up, pushing down their prices and with it the profitability of domestic businesses. As a result, despite incomes having gone up (due to lower prices), domestic businesses may shut down and capital leaves the country. Therefore here we can see that when people’s productivity does not go up, but their income does go up, then naturally they become uncompetitive.
- The problem with an exchange rate strengthening due to investor demand is if the cash that was obtained by foreign investors does not ultimately flow into a greenfield investment, and instead it simply fulfills someone’s desire to hold cash. In such a case, cash that would otherwise have been used to buy goods and create demand, sits idle instead and so results in demand and economic activity going down.
- The reason the Chinese government controls the exchange rate is to make investing into China more attractive. They do this with the belief that attractive conditions for foreign investment creates more jobs in China (and more rapidly) compared to higher profitability for domestic firms if exchange rates weren’t capped.
