Currency is a lot like marmalade. And Barbie dolls. And duct tape and coffee and anything else that is bought and sold: It follows the law of supply and demand.
“Whatever the supply and demand is in the foreign exchange market, that’s what determines the foreign exchange rate,” says Win Thin, global head of emerging markets at Brown Brothers Harriman.
If a currency is popular, its price (in terms of other currencies) will rise. If it’s not so popular, its price will fall. So when countries fool around with their exchange rates, they have to in some way manipulate supply and demand. Here’s how:
Play with interest rates.
Raise interest rates, make your country a popular place for investors, who will then purchase your currency to invest and bid up the price of your currency.
Lower interest rates, your country becomes less of a lucrative place to park money, investors aren’t that interested in buying your currency, and the price goes down.
Play with supply
Go out and sell your money! At a discount! Make it a dime a dozen if you have to! Central Banks can basically whip up money out of nowhere and sell it in currency markets, driving down the price.
Play with demand
If you’re an export-heavy country, you’ll have some amount of dollars or euros or yen stored up in your Central Bank. Take those dollars/euros/yen/etc., go into currency markets, and buy your own currency. It’ll increase demand and bid up the price. It’s kind of like leaving your own Yelp review.
Many emerging market countries have what’s known as a “dirty float” where they let the market determine some of a currency’s exchange rate, but keep a close eye on it and step in to keep it within certain boundaries. These days, devaluation in particular is a popular strategy.
“At a time when many countries around the world are looking for any possible sources of growth, it’s tempting to turn to exports,” says Eswar Prasad, professor of trade policy at Cornell.
The U.S. and Europe generally say it’s cheating when a country goes out and buys/sells currency to manipulate its value. They’ve accused China of doing so in the past, but they can’t say that this time. China isn’t pushing its currency down in this case, it’s letting it fall.
“In the past, the market was trying to make the currency of China stronger, and they were resisting,” says Robert Lawrence, professor of international trade at Harvard’s Kennedy School. “Currently, the market is trying to move their currency weaker, and they’re going along with it.”