Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.
In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.
The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.
The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP). The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country. The table below illustrates the metrics discussed thus far.
Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com
Note on exchange rate rank: It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.
Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.
It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.
EXCHANGE RATE DETERMINATION
According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:
First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.
Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.
Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.
The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.
Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.
In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.
 For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.
Anupam Manur is a Policy Analyst at Takshashila Institution and can be found on twitter @anupammanur
Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter @_quale