When valuing a country’s currency in another country’s currency, the fundamental analysis includes studying macroeconomic indicators, asset markets, and political factors. Macroeconomic indicators include economic growth rates, which are calculated from factors such as gross domestic product, interest rate, inflation rate, unemployment rate, money supply, foreign exchange reserves, and productivity. The asset market includes stocks, bonds, and real estate. Political factors will affect the trust in a country's government, social stability, and confidence.
Sometimes the government will intervene in the currency market to prevent the currency from deviating significantly from undesirable levels. The central bank executes intervention in the money market and usually has a significant but temporary impact on the foreign exchange market. The central bank can unilaterally buy/sell its currency in another country's currency or jointly intervene with other central banks to achieve more significant results. Or, some countries can try to influence currency changes only by issuing hints or threats of intervention.
Purchasing Power Parity (PPP)
Purchasing power parity theory stipulates that the exchange rate is determined by the relative prices of the same commodities group. Changes in the inflation rate should be offset by changes in the exchange rate of the same amount but in the opposite direction. Take a classic example of a hamburger. If a hamburger is worth US$2.00 in the United States and a pound 1.00 in the United Kingdom, then according to the theory of purchasing power parity, the exchange rate must be US$2 per pound. If the prevailing market exchange rate is 1.7 US dollars per British pound, then the British pound is called an undervalued currency, and the U.S. dollar is called an overvalued currency. This theory assumes that the two currencies will eventually change to a 2:1 relationship.
The main disadvantage of the purchasing power parity theory lies in its assumption that goods can be freely traded, and transaction costs such as tariffs, quotas, and taxes are not counted. Another shortcoming is that it only applies to goods but ignores services, which can have a significant value gap space. In addition, in addition to the difference in inflation rate and interest rate, several other factors affect the exchange rate, such as economic data release/report, asset market, and political development. Before the 1990s, the purchasing power parity theory lacked factual evidence to prove its validity. After the 1990s, this theory seems to only apply to extended periods (3-5 years). In such a span of the cycle, the price eventually moved closer to parity.
Interest rate parity (IRP)
Interest rate parity stipulates that changes in interest rate differences will offset one currency's appreciation (depreciation) against another. Suppose the US interest rate is higher than the Japanese interest rate. In that case, the dollar will depreciate against the yen, and the extent of the depreciation depends on the prevention of risk-free arbitrage. The future exchange rate will be reflected in the forward exchange rate specified on the day. In our example, the forward exchange rate of the U.S. dollar is considered a discount because the Japanese yen purchased at the forward exchange rate is less than the Japanese yen purchased at the spot exchange rate. The yen is viewed as a premium.
After the 1990s, there is no evidence that the interest parity theory is still valid. Contrary to this theory, currencies with high-interest rates generally do not depreciate but increase in value due to the long-term suppression of inflation and is a highly efficient currency.
Balance of payments model
This model believes that the foreign exchange rate must be at its equilibrium level-that is an exchange rate that can generate a stable current account balance. A country with a trade deficit will reduce its foreign exchange reserves and eventually reduce (depreciate) the value of its currency. Cheap currency gives the country's goods more price advantage in the international market and makes imported products more expensive. After a period of adjustment, the volume of imports was forced to fall, and the importance of exports rose, thereby stabilizing the balance of trade and currency.
Like the purchasing power parity theory, the international balance of payments model mainly focuses on traded goods and services while ignoring the increasingly important role of global capital flows. In other words, money is not only chasing goods and services, but more broadly, it chases financial assets such as stocks and bonds. Such capital flows enter the capital account of the balance of payments, which can balance the deficit in the current version. The increase in capital flows gave rise to the asset market model.
Asset market model (the best model so far)
The rapid expansion of financial assets (stocks and bonds) has given analysts and traders a new perspective on currencies. Economic variables such as growth rate, inflation rate, and productivity are the only drivers of currency changes. The share of foreign exchange transactions originating from cross-border financial asset transactions has dwarfed currency transactions arising from trade in goods and services.
The asset market approach treats currency as the price of an asset traded in an efficient financial market. Therefore, currency increasingly shows its close relationship with asset markets, especially stocks.
U.S. dollar and U.S. asset markets
In the summer of 1999, many authorities believed that the U.S. dollar would depreciate against the euro, citing the growing U.S. current account deficit and the overheating of the Wall Street economy. The theoretical basis for this view is that non-US investors will withdraw funds from the US stock and bond markets and invest them in markets with healthier economic conditions, thereby drastically depressing the value of the US dollar. And such fears have not dissipated since the early 1980s. At that time, the U.S. current account quickly grew to a record high, accounting for 3.5% of gross domestic product (GDP).
Just as in the 1980s, foreign investors still have such a greedy appetite for American assets. But unlike in the 1980s, the fiscal deficit disappeared in the 1990s. Although the growth rate of foreign holdings of U.S. bonds may have slowed down, the continuous injection of large amounts of funds into the U.S. stock market is enough to offset this slowdown. When the US bubble bursts, non-US investors are most likely to choose safer US Treasury bills than Eurozone or British stocks because Eurozone or British stocks are likely to be struck in the above incident. In the crisis of November 1998 and the panic caused by the false statements of Federal Reserve Chairman Greenspan in December 1996, such situations have already occurred. In the first case, the net purchases of foreign Treasury bills almost tripled to US$44 billion; in the latter case, this indicator surged more than tenfold to US$25 billion.
In the past two decades, the balance of payments law has been replaced by the asset market law in estimating the dollar's behavior. Although the improvement of the fundamental elements of the Eurozone economy will surely help this young currency regain its lost ground, it isn't easy to support this recovery solely based on essential features. Today, there still exists the credit problem of the European Central Bank; up to now, the credit of the European Central Bank is inversely proportional to the frequent verbal support of the euro. The looming risks of the government stability of the Eurozone’s Big Three (Germany, France, and Italy) and the expansion of the European Monetary Union are also seen as potential obstacles to the single currency.
At present, the stability of the US dollar can be attributed to the following factors: zero inflation growth, the safe-haven nature of the US asset market, and the euro risk mentioned above.