Several points come to mind.
First, the suggested analogy between currency exchange rates and the prices private firms charge for their products doesn’t really help in understanding the issues. When a private firm offers a product for sale, it knows how much the product cost to produce, and can choose how much of the product it wants to produce and sell to the public. In these decisions, the firm is guided by a desire to maximize profits; its managers can apply any information they have on the firm’s degree of market power in the particular market in question, along with any other insights they have on the state of the market, in choosing the price at which they offer to sell the product. In most cases, the firm sets its price with due consideration of the prices charged by its competitors, which in many cases will substantially limit the range of prices at which it can expect to attract any customers.
In contrast, currencies are not all that similar to the goods and services produced and sold by private firms – they are instead financial assets, and are best analyzed with that in mind. Rather than drawing an analogy between currencies and the products produced by private firms, it’s better to compare them to the financial assets issued by firms, such as stocks and corporate bonds. And of course, in general private firms do not choose the price at which their stocks and bonds are sold – those prices are set in financial markets. One reason that’s so is that there’s no production cost underpinning the price of financial assets: once they’ve been issued, their prices depend almost entirely on the demand for those assets, which in turn is strongly affected by shifting expectations about the returns on those assets vis-à-vis other assets that might be held in the portfolio. Successfully second-guessing the market as to the market-clearing value of a financial asset is likely to be far beyond the ability of most governments.
Second, many governments do set the price of their currency, by committing themselves to a fixed exchange rate – a commitment to buy or sell foreign exchange to their own citizens at a fixed price. Mathematically, the price of foreign exchange in terms of domestic currency is simply the inverse of the price of domestic currency in terms of foreign exchange. But that way of thinking obscures the underlying reality that for most countries – all but the few that issue international reserve currencies – the only source of demand for their national currency is from their own citizens, and that only because of the designation of that currency as legal tender within the country. As a result, rather than thinking about governments “setting the price of their currencies,” it’s much more realistic to describe these governments as setting the price of foreign exchange – the commitment to buy and sell FX at a fixed price mentioned above.
In principle, governments have every right to fix the exchange rate at whatever rate they want. However, it is widely recognized that maintaining a fixed exchange rate requires that the government manage its overall macroeconomic policy stance so as to maintain that commitment. Indeed, doing so requires that the government manage aggregate demand so that the fixed exchange rate remains very close to the equilibrium rate that would emerge if the government dropped its commitment and simply allowed market forces to determine the exchange rate. Failure to do so typically leads to overvaluation of the currency, which undermines the international competitiveness of the country’s exporting and import-competing firms, encourages excess demand for imports, and thereby causes the country’s foreign exchange reserves to dwindle. Unless the government undertakes remedial action, those FX reserves will eventually be exhausted, at which point it becomes impossible for the government to sustain its commitment to the fixed exchange rate – it is forced to devalue, hopefully to a new value that the government can defend. But such forced devaluations are generally politically traumatic and usually associated with a financial crisis. Alternatively, many governments impose various controls in order to slow the outflow of foreign exchange without undertaking the macro policy changes needed to do so; those controls are typically very damaging to the national economy. As a result, having an overvalued exchange rate is one of the most powerful predictors of future economic crisis, typically involving a lengthy period of slow growth or actual decline.
For this reason, the International Monetary Fund pays careful attention to evidence of overvaluation, and urges governments with overvalued currencies to take remedial action before it is too late. Similarly, if a country has fallen into a crisis, the IMF will generally require that the government devalue the currency as a precondition for extending short-term loans to help the country weather the crisis.
In short, governments have the right to price their currency – or more accurately, to price foreign exchange – at whatever level they want. However, trying to sustain a price that is very far from what the market would dictate is generally impossible in the medium and long run, and in the short run inflicts enormous economic damage. In these situations, the market has the final say.
The value of any country’s currency is linked to many valuation factors of which the issuing country has little to no control. In a normal environment without market stressors, one of the prime determinants of a currency’s valuation is the level of interest rates in the issuing country compared to other currencies local equivalent rate of interest.
For example, if the overnight rate for UK was 15% and the US was 1%, you would rather have your money sitting in a short term demand deposit account earning 15%.
Other factors that contribute to a currency’s valuation are any inherent technical functions of the currency such as a hard link to the USD or other major currency.
Topical as well aresanctions imposed on a country will also hurt its valuation.
Political instability is also a key driver of valuation.
A country’s sovereign debt and local currency credit rating as determined by one of the major rating agency’s also serves to strengthen or weaken a currency.
A rather boring but useful read would be either S&P or Moody’s sovereign rating guidelines.
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