Summary. A look at policies a country can consider to increase the value of a currency.
Readers Question: I was wondering, what are some of the policies and possibilities a country can use to increase the value of their currency? Specifically, countries who would be trying to “overthrow” the US dollar like China, India, Brazil, Russia etc.
To increase the value of their currency, countries could try several policies.
- Sell foreign exchange assets, purchase own currency
- Raise interest rates (attract hot money flows
- Reduce inflation (make exports more competitive
- Supply-side policies to increase long-term competitiveness.
1. Sell foreign exchange assets and buy their own currency
China has over $1.4 trillion of US government bonds. If the Chinese sold these Treasury bills and brought back the proceeds to China, this would cause a depreciation in the dollar, and the Chinese Yuan would appreciate. (supply of dollars would rise, and demand for Chinese Yuan would increase) Because China has substantial dollar assets, they could cause a reasonably significant fall in the value of the dollar.
In fact, China could appreciate the value of their currency simply by not buying any more dollar assets. Currently, China has a large current account surplus with the US. This flow of money into China would usually cause an appreciation. However, China has deliberately decided to use its foreign currency earnings to buy US assets. They do this to keep the Yuan weaker and therefore keep their exports more competitive.
In the case of Russia and Brazil, they only have relatively limited dollar reserves. Therefore, there is only limited scope for selling dollars and buying their own currency.
2. Higher interest rates
Higher interest rates would attract some ‘hot money flows‘. Hot money flows occur when banks and financial institutions move money to other countries to take advantage of a better rate of return on saving. Given interest rates are close to zero in the US, higher interest rates in developing countries give a significant incentive to move money and savings there.
- However, as a drawback, higher interest rates may reduce the rate of economic growth (see the effect of higher interest rates). In many circumstances, e.g. in recession, higher interest rates would not be suitable due to side effect on economic growth. Though if the economy was booming, higher interest rates would cause an appreciation and moderate the rate of economic growth.
At the moment, it is hard to find a country which wants to have a stronger exchange rate. For example, Switzerland was once seen as a ‘safe haven’ currency. This caused investors to buy Swiss Francs. However, the Swiss government and Central Bank were worried about the appreciation in the Swiss Franc causing problems for exporters. If a country gave a credible assurance that they were targeting a higher exchange rate, this might encourage speculators to move money into that country.
4. Reduce inflation
If inflation is relatively lower than competitors, then the countries goods will become more attractive and demand will rise. Lower inflation tends to increase the value of the currency in the long term. To reduce inflation, the government / Central bank can pursue tighter fiscal and monetary policy and also supply-side policies.
4. Long-term supply-side policies
In the long term, a strong currency depends on economic fundamentals. To have a stronger exchange rate, countries will need a combination of low inflation, productivity growth, economic and political stability.
For example, if India increased interest rates, this might not be enough to cause an appreciation in the exchange rate. This is because, despite high-interest rates, investors would be concerned about the high inflation in the Indian economy.
To increase the value of the currency in the long-term, the government will need to try supply-side policies to increase competitiveness and cut costs of production, for example, privatisation and cutting regulations may help the export industry become more competitive in the long-term.
Difficulties of influencing the exchange rate
It is worth mentioning that it can be difficult for many governments to influence the exchange rate.
- In 1992, the UK tried to keep the Pound in the ERM. The government sold foreign exchange and bought pounds and also increased interest rates. However, the markets didn’t think this was sustainable and kept selling Pounds. Ultimately the government had to give in and allow the Pound to devalue.
- If a country like Canada relies on commodities for foreign currency earnings, then it is hard to increase the value of the currency when the price of commodities is falling. If the price of oil falls, then currencies like the Russian Rouble will tend to fall because the value of oil exports declines. The only solution would be to try and diversify the economy away from oil into other manufacturing, but this will take a long time.
- Lower wage costs are important for helping the exchange rate in the long-term, but it can be quite time-consuming and difficult to reduce wage inflation in a country.
Do countries want a stronger exchange rate?
A strong currency is a mixed blessing. It makes imports cheaper and can improve living standards. However, it can also make exports less competitive and lead to lower economic growth. See: Impact of appreciation