- Smart Investing
What makes a currency strong?
I was speaking to a friend the other day. He’d just been to China as was mentioning that the Chinese Yuan was a “weak” currency as it was 7 Yuan to the US Dollar. This started a 30 minute long conversation where I tried and failed to convince him that the conversion rate really had nothing to do with the strength of the currency. I’ll try to replicate that explanation here - will be easier with some facts
Let’s look at some currencies and their exchange rate against the Canadian dollar (CDN).
1 CDN = 5.34 Yuan (Chinese Currency)
1 CDN = .76 USD (US Dollar)
1 CDN = .68 Euros
Based on the reasoning described above, you can conclude that the Euro is the “strongest” currency of this group. If we extend this logic, then the “strongest” currency would be the Kuwaiti Dinar, currently trading at .23 Dinar for each Canadian dollar.
But what does strong really mean? Since 1 Dinar can buy more than one of any other currency, it does seem to be stronger and this is where people get confused. But the reality is that currencies are designed to have a certain exchange rate with other currencies. For example, Japan, a very strong economy, has an exchange rate with the Canadian dollar of 1 CDN = 82.39 Japanese Yen and it has been around the same exchange rate for years (although it does go up and down). So, is the Japanese Yen really weak?
No, of course it isn't. In Canada, a quick lunch might cost $12 CDN. In Japan, that same lunch is probably 1,000 Yen. Since 1,000 is so much bigger than 12, you might conclude that lunch costs more in Japan. But of course, the difference is only the exchange rate - $12 CDN X 82.39 is (approximately) equal to 1,000 Yen. Japanese people get paid in Yen and Canadians get paid in Canadian Dollars. For the same job a Japanese person would make many more Yen than a Canadian would make in Canadian Dollars. But, that lunch for the Japanese person would feel just as expensive as the same lunch for the Canadian as she would have to spend the same percentage of their salary.
So, if we can’t use the exchange rate, what makes a strong currency? Currencies are strong when they are going up in value relative to another currency. For example, sticking with Japanese Yen, in 2014/2015 the exchange rate was 100 Yen = 1 CDN. So, since 2014/2015 the Yen has strengthened against the Canadian Dollar.
Let’s look at the USD to CDN over that same time period. In 2014/2015 it was about $.90 USD to $1 CDN compared to about $.74 USD to $1 CDN now. So, the USD has also strengthened against the Canadian Dollar
Poor Canadian Dollar! But fear not. Thanks to Brexit, the Canadian Dollar has been strengthening against the British Pound. The fact that 1 CDN equals less than one GBP ($.57 Pound) doesn’t make the Canadian dollar weak.
A currency’s strength reflects the changes relative to other currencies over time. Projecting where an exchange rate between two currencies will go is very complicated work as it is affected by many factors. If you can figure it out, you could become a currency trader and make millions.