If a nation's currency is "undervalued," it means the rate at which it can be exchanged for other world currencies is too low. But you don't have to be a foreign exchange trader to feel the effects of an undervalued currency. If you buy stuff made in foreign countries – or work for a company that sells items overseas – then currency values have a real impact on your bank account.
TL;DR (Too Long; Didn't Read)
A currency is undervalued when it has low foreign exchange value based on the current economic conditions.
Basics of Currency Exchange
If you've ever traveled abroad, you know about currency exchange. In the United States, you use good old American dollars to buy things. In Europe, you use euros. In Japan, yen. In Mexico, pesos.
When you go abroad, you trade dollars for the local currency. One U.S. dollar might get you 0.75 euros, or 98 yen, or 13 pesos. What you get for your $1 is determined by the current exchange rate between the U.S. dollar and that local currency. Exchange rates are always changing based on a world's worth of economic factors.
Defining Undervalued Currency
A currency is considered undervalued when its value in foreign exchange is less than it "should" be based on economic conditions, at least in the opinion of currency traders, economists or governments. For example, say that foreign exchange traders believe $1 is the equivalent of 4 Chinese yuan, meaning 1 yuan should get you 25 cents. But if the actual exchange rate is 6 yuan to the dollar – meaning 1 yuan gets you only about 16 cents – then the yuan is viewed as undervalued. You don't get as much bang for your yuan as you should.
Reasons for Undervaluation
A currency may be undervalued simply because there's insufficient demand for it. If no one wants to buy the Botswana pula, then the pula is probably going to be undervalued no matter how healthy Botswana's economy is. But governments also deliberately undervalue their currencies – for example, by manipulating the money supply or setting artificially low exchange rates. They do this because they know that you like to save money.
Consumer Effect of Undervaluation
If the Chinese yuan is undervalued in relation to the dollar, then Chinese-made products are cheaper in the U.S. Say a Chinese company sells its doodads for 5 yuan. If the exchange rate is 4 yuan to the dollar, then that doodad costs you $1.25 when you buy it here in the United States.
But if the yuan is undervalued and the exchange rate is 6 yuan to the dollar, suddenly that doodad is only about 83 cents. An undervalued yuan thus boosts Chinese exports, while at the same time making U.S.-made goods more expensive in China.
Political Effects of Undervaluation
The yuan is a good example to use when illustrating undervaluation because the U.S. and other governments regularly accuse China of undervaluing its currency to aid its exporting industries at the expense of those in other countries. An undervalued currency allows a country to essentially impose a tax on imports, but without running afoul of international trade rules that prohibit taxes that are actually called taxes.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.