Proper valuation of a currency keeps a currency’s price in sync with economic fundamentals and prevents asset bubbles and inflation

The foreign exchange market seeks to use a market-based mechanism to discover a price for a currency. But, this price discovery mechanism is hampered by a variety of externalities, chief of which is the different intermediaries involved in the trading and clearing of a currency. Such intermediaries introduce delays in the transmission of market information, where the price of a currency could fluctuate on a minute-basis. Although prices do adjust itself eventually, some mis-calibrated prices of currency could persist longer, resulting in a mis-alignment of a currency’s price with the fundamentals of an economy. Beyond such technicalities, a currency’s price could also be mis-aligned if there is economic mismanagement or speculative attacks on a currency whose price may be too high. But, nevertheless, proper valuation of a currency’s price is fundamental to sound economic management by a country. This fine-tuning or adjustment is usually performed by the deft hands of a country’s central bank. However, regulatory action is often delayed by months compared to the hours and days in which large mis-alignment in a currency’s value could be built up through short-selling. Overall, a mis-aligned currency’s value needs to be corrected, but, prior to active open-market operations by the central bank to adjust a currency’s value towards a more sustainable trajectory, improper valuation of a currency’s price could result in large inflows and outflows of funds into an economy, with potential to create asset bubbles and inflation, or poor economy growth and deflation. Specifically, if a currency is artificially cheap, it drives inflow of funds into an economy. Such cases have been observed in the emerging markets such as India and Brazil, and crave for the local currency and its use drives asset bubbles and inflation. Although a cheap currency encourages exports, economies with low manufacturing capacity stand to lose more compared to what it gains from a cheap currency. On the other hand, a currency that is too strong hampers investment, and job creation in an economy. By generating an external demand for the currency for risk averse investors, central banks would need to expand the monetary base to cater to currency demand, a move which may sow the seeds for future crisis as seen in the Federal Reserve of the United States, which have struggled for years to scale back an outsized balance sheet. Collectively, modern monetary trading mechanism may still be inefficient in transmitting economic indicators into the market for a proper valuation of a currency’s price. While mis-alignment in currency’s price could be corrected in due course by a central bank, mis-reading of the economic fundamentals and political expediency may ultimately sow the seeds for a longer mis-calibration of a currency’s price, with results that need to be borne by the constituents of the economy, both corporate and personal.