Dear Straight Dope:
I was recently in the company of a person from Latvia who told me that their dollar has always been worth more than the American dollar. I found this hard to believe and looked it up and sure enough, it is almost double the U.S. dollar! How is that possible if we're the richest country in the world? How are currency rates determined? Why is the British pound always worth more than the U.S. dollar and what's up with Latvia's dollar being worth more than ours?! Do they have a lot of gold in their hills? Is it oil? Has the whole world gone crazy? Please help, I'm . . .
Man, where to start? Just because a country’s basic unit of currency is worth more than ours doesn’t mean the country is richer. If you think that 100 pennies is "richer" than 10 dollars because the absolute number is bigger, then we’re not going to have much luck dealing with foreign exchange rates.
Think of currencies as if they were units in different systems of measurement, like inches and centimeters. You can convert inches to centimeters because you know that 1 inch = 2.54 cm. That doesn’t mean things measured in inches are bigger than those measured in centimeters. Same with foreign currencies. As of today (Sept. 1, 2003), 0.57 Latvian lats = U.S. $1, and U.S. $1.75 = 1 Latvian lat. In itself this means nothing. With me so far?
A common myth is that if a currency is worth less than $1, it’s weaker than the U.S. dollar, and if it’s worth more, then it’s stronger. Your Latvian friend is trying to pull this on you, but it’s nonsense.
There is no necessary relationship between the exchange rate of a foreign currency relative to the U.S. dollar and the strength of the issuing country’s economy or its wealth. Consider a few examples. Some of the strongest currencies other than the U.S. dollar (that is, ones preferred by investors, because their value is stable) are the British pound (at 0.63 per dollar), the Japanese yen (at 116 per dollar), the Swiss franc (at 1.40 per dollar), and the European euro (at 0.90 per dollar). The yen is a particularly striking case. Although the Japanese have had their problems in recent years, they still have one of the largest economies in the world and are wealthy by any standard. Yet one yen is worth less than a penny.
Currencies worth more than a dollar include the Bahrain dinar (at 0.38 per dollar), the Maltese lira (at 0.38 per dollar) the Cayman Islands dollar (at 0.83 per dollar), the Omani reale (at 0.38 per dollar) and the Jordanian dinar (at 0.70 per dollar.) All of these are from small-to-tiny countries with economies to match and in some cases considerable poverty. The gross domestic product of Jordan, for example, was only U.S. $1,553 per capita in 1998. None of these currencies is a major factor in international trade.
Another way to think about currency exchange rates is that they’re like stock prices. The fact that one company’s stock price is higher or lower than another’s doesn’t necessarily tell you anything about which company is stronger or the better investment. You decide that based on the movement of the price over time.
That’s the key, you see–the trend over time. It’s fairly easy for a country to artificially boost the value of its currency in the short term. One way, often employed by countries plagued by hyperinflation, is to replace old simoleons with new ones at some fixed ratio–say, 100, 1,000 or even 10,000 to 1. That’s what happened in Latvia. Up until 1991 Latvia was part of the Soviet Union and used the ruble. After independence Latvia issued its own rubles whose value was pegged to the Russian ruble. Economic conditions were unsettled and the value of the Latvian ruble soon tanked–at one point the exchange rate was 105 Latvian rubles to U.S. $1. In 1993 the Latvian government decided to replace the Latvian ruble with the lat at a rate of 200 to 1. That made the lat worth about $2, and it has devalued slightly since then.
After the government does its thing, the implacable forces of the market take over. Had inflation continued in Latvia, the value of the lat would soon have plummeted and today it might be worth only pennies. However, if you believe what you read on the Web–I know I believe everything I read–Latvia has pursued "sound money" policies over the past few years and the value of the lat in consequence has remained stable (and recently has increased) relative to the dollar. That’s good, but it still doesn’t mean Latvia is rich. Latvian citizens on average have only a quarter of the purchasing power of citizens of European Union countries.
I think that basically answers your question. But you may still wonder: Why do the values of currencies fluctuate relative to one another over time? How are rates determined? If you’ve taken Econ 101, you can guess the answer–it’s all a matter of supply and demand.
Earlier I said you should think of different currencies as being like different systems of measurement, such as inches and centimeters. Unlike the conversion ratios for measurements, though, currency exchange rates are constantly shifting. The conversion rate for Latvian lats to dollars changes every day, in fact, more often than every day. What’s more, there’s not just one conversion rate, but different rates for different circumstances. To understand that, we need to start with how currencies work.
WHY ARE THERE DIFFERENT CURRENCIES?
Today we take it for granted that each country issues its own currency to facilitate trade. Centuries ago things were handled more casually. The U.S., for example, didn’t declare the dollar the standard monetary unit until 1785 and didn’t issue its own money until 1794–before then we used whatever foreign cash we could get our hands on. Now everyone’s more organized. The U.S. has the dollar ($), in the U.K, it’s the pound (£), in Japan, the yen (¥), etc. Many countries use the dollar sign ($) for their currency–in Mexico, for instance, prices are labeled $10 meaning 10 Mexican pesos. To avoid confusion, the international financial community has developed a set of initials: USD for U.S. dollars, GBP for British pounds, JPY for Japanese yen, MXP for Mexican pesos, and LVL for Latvian lats, for instance.
WHY DO YOU NEED TO EXCHANGE CURRENCIES?
You need to convert money because, generally speaking, in any given nation, only the local currency is legal tender for trade. A U.S. tourist cannot walk into a restaurant in Tokyo and pay with U.S. dollars–the cashier in all likelihood will only take yen. U.S. dollars are not recognized as legal tender in Japan. Fortunately, American tourists can stop at a bank or currency exchange kiosk that will exchange dollars for yen so they can buy things in Japan. Likewise, Japanese tourists exchange yen for dollars when they visit the U.S.
A few exceptions to the general rule, before we go on:
- In the early days of American independence, each state had its own currency. If you went from Philadelphia to New York, for instance, you needed to convert currency. For instance, by November 1777, Samclem tells me, it took two Pennsylvania dollars to buy one New York dollar. Fortunately, the U.S. Constitution established that currency be regulated by the federal government and not the states. Thus we now have one U.S. currency that is recognized and accepted in all states, greatly simplifying interstate commerce, I’m sure you’ll agree.
- The European Union last year adopted a single currency, the euro (€), which is presently used in twelve European countries (more will join in future.) Back in the 1990s, if you were traveling in Europe, you would buy things in France with French francs, in the Netherlands with Dutch guilders, and in Germany with deutschmarks. Now all those countries use the euro. The euro is also accepted in several other countries, such as Monaco and the Vatican.
- While the general rule is that you must buy things in a local currency, there are exceptions, and many countries will accept U.S. dollars as payment. These are usually third-world countries with weak economies and high inflation, and locals are willing to accept dollars. If you are travelling, you should check first to find out the situation–a French bookseller would be highly offended if you offered to pay in dollars, whereas a Kenyan bookseller might be quietly glad to take dollars.
Tourists, of course, are only minor players in the great game of currency exchange. Companies engaged in international trade and investment, on the other hand, must routinely convert enormous sums. For example, a company buying timber from Brazil must convert U.S. dollars into Brazilian reais. Large companies, and even small investors, can "play" the investment markets, gambling on currencies the way most investors gamble on stocks. An investor might convert funds from U.S. dollars into Swiss francs, for instance, to invest in (let us say) higher interest-paying accounts.
HOW ARE THE OFFICIAL EXCHANGE RATES DETERMINED?
As we said before, not only do rates change constantly, there are several different rates, just to make life confusing. No universal rules apply–it’s basically a matter of barter. Factors affecting the official exchange rates include: (a) the market, (b) government policies, and less importantly, (c) history and (d) banks.
First, a quick definition. When two parties agree to exchange currency and execute the deal immediately (or that same day), the rate they agree upon is called a "spot rate." When you as a tourist convert your currency at a bank or kiosk, the bank uses the spot rate of the day.
Exchange rates are primarily determined by the interaction of supply of and demand for one currency relative to another. If many people want U.S. dollars and few want Latvian lats, and there are lots of lats–I bet currency traders love saying that–then the dollar will appreciate against the lat. Things can go the other way, too. Browsing some more on the Web, I find that between early April and mid-June of 2002, the dollar depreciated against the lat from LVL 0.645 (roughly) to LVL 0.613. That trend has continued, since the dollar today is valued at LVL 0.57. So while the lat has depreciated a bit against the dollar since 1993, your Latvian friend can comfort himself with the thought that it has strengthened lately.
The spot rates that banks use are generally based on published information. Each government announces its "official" exchange rate (these are the ones printed in the Wall Street Journal each day). The actual rates that banks use can vary from the published rates.
Governments have policies for setting their currency rates, some less logical than others. In times of inflation, for instance, a government tends to print more money, which raises the supply, making it easier to borrow money, causing a demand for more goods and services, and so the inflation spirals. By affecting the supply, the foreign demand, however, may decrease, and the currency will devalue over time. For instance, many Latin American countries, faced with hyperinflation in the 1980s, tried to freeze their currencies. That didn’t stop inflation or devaluation and was a pretty stupid policy, but there you go.
Governments that maintain too tight a rein on their currency run the risk that no one outside the country will want that currency. That was a problem with the Communist regimes before the fall of the Soviet Union–their local currencies were worthless on foreign markets. As I write, the U.S. government is requesting that China unfreeze its government-controlled currency, to allow market factors to affect the price.
Currency rates generally aren’t completely arbitrary; they reflect history. As I’ve indicated, some countries change their currency in the face of hyperinflation. In the 1980s and early 1990s, Brazil changed its currency three times, from the cruzado to the cruzeiro to the reale, usually by dropping four zeroes. Other countries decide to stay with their currency, so you wind up with the Turkish currency being several hundred thousand to the dollar.
In some countries, official exchange rates are fixed, and every bank must (by law or by agreement) charge the same thing. In other countries, banks are free to charge what they wish, and different banks may offer different spot rates.
ARE THERE UNOFFICIAL EXCHANGE RATES?
The official exchange rate is set daily by the government, based on market factors and government policies. But there are other rates as well:
Long-term rates: Spot rates fluctuate daily, but businesses need more stability–they don’t want prices to vary based on unpredictable factors. Hence, companies usually negotiate an exchange rate that they agree to use for a transaction, usually based on a 30-, 90-, or 180-day time frame for their deals. Dealing with the risk that a foreign currency will devalue against the dollar (for example) is a big-time business in the world of global finance.
Black market rates: "Black market" rates usually arise when governments freeze the exchange rates or otherwise try to manipulate the currency markets. In such cases a "black market" (sometimes called "free market") almost invariably springs up, buying and selling that currency at a market-driven rate rather than the official one.
Samclem of the Straight Dope Science Advisory Board tells me that if you went to Iraq before the war, you had to pay three U.S. dollars to buy one Iraqi dinar at the "official" rate. But if you purchased your Iraqi dinar in New York at the "unofficial" rate, your three U.S. dollars would have bought an astounding 5,400 dinar. On the other hand, I checked around and it appears there is no black market for the Latvian lat–the official rate is pretty much the same as the free market rate.
In some countries, unofficial (black market) currency exchange is illegal, so be cautious upon arriving in a country if someone offers you a better exchange rate than you’d get at the banks–you may be risking a fine or jail.
Purchasing power rates: Purchasing power parity (PPP) is an exchange rate that reflects a market basket of goods. This is sometimes called the "Big Mac" rate, the idea being that if you compare the price of a McDonald’s Big Mac in different countries, you get a better idea of the true barter rate. The PPP rate is rarely used in actual transactions; it’s more often used by economists trying to compare living standards. Sometimes companies use this rate to determine how much money their employees need when traveling or living abroad.
Circling back to the original question, the real way to measure whether the Latvian lat is "worth more" than the dollar is to ask how much it can purchase. Just for the helluvit, the Big Mac exchange rate as of January 15, 2003 in the Economist showed that a Big Mac cost $2.65 in the U.S. vs. £1.99 in the U.K., which would give an exchange rate of 0.75 rather than the actual rate of 0.63. In Japan, the cost of a Big Mac was ¥263, giving an exchange rate of 99 rather than the actual 115; and in Europe, the Big Mac was €2.75, giving an exchange of 1.03 rather than the actual 0.90. This suggests that the pound and euro are currently overvalued against the dollar, and that perhaps you could play the currency markets in the expectation of future depreciation.
IF I’M TRAVELING, HOW DO I FIND THE BEST EXCHANGE RATE?
The official spot rate published in major newspapers isn’t necessarily the most attractive rate. There may be slight differences among banks, depending on the amount of regulation in that country. Usually the banks move together in setting their spot rates, due to market pressures, government regulation, or collusion. But not always. So you could do a little shopping. Be aware that the spot rate you get from an ATM is usually better than what you would get from a bank or currency kiosk. The spot rate at a hotel is usually worse.
Is shopping for the best rate worth the trouble? Depends. A tourist exchanging a few hundred dollars may lose a couple of dollars by not shopping for the best rates–big deal. But if you’re a company converting millions of dollars, the extra decimal place in the conversion rates can certainly add up.
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