Exchange Rates and International Financial Economics

History, Theories, and Practices

J. Kallianiotis

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137318886
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

The recent financial crisis has troubled the US, Europe, and beyond, and is indicative of the integrated world in which we live. Today, transactions take place with the use of foreign currencies, and their values affect the nations' economies and their citizens' welfare. Exchange Rates and International Financial Economics provides readers with the historic, theoretical, and practical knowledge of these relative prices among currencies. While much of the previous work on the topic has been simply descriptive or theoretical, Kallianiotis gives a unique and intimate understanding of international exchange rates and their place in an increasingly globalized world.

1

History of Exchange Rate

In finance, an exchange rate or a foreign exchange rate or a forex rate or an FX rate (i.e., e_t($/€)) between two currencies is the rate at which one currency will be exchanged for another. Exchange rate is the price (value) of one country’s currency in terms of another country’s currency. The history of money goes back thousands of years. Numismatics is the scientific study of moneys and their history in all their varied forms and functions. Many items have been used as commodity money, such as animals, barley, wine, oil, cowrie shells, beads, and naturally occuring rare precious metals and stones, as well as many other things that be considered as valuable to the average person. Most ancient moneys started to become tokens a long time ago. The word “nomisma”¹ (derived from nomos = anything assigned, a usage, a custom, a law, an ordinance), meaning coin, was and still is used by Greeks for “currency” and “money.” Historically, the island of Aegina (Greece) participated in the early days of coinage (silver coins since 670 B.C.), the first money in Europe. Then, coins were minted in Athens, Corinth, Euboea, Syracuse, and in other Greek city-states and their colonies. Hence, objects of gold or silver or copper present many of money’s essential properties. Modern money appeared in paper currency form (banknotes) as early as the Ptolemaic Egypt (first century BC), and in Europe during the fourteenth century AD, and as coins much earlier. The industrial revolution, the independence of European nations, the economic boom, and the increase in trade of the late nineteenth and early twentieth centuries led us to a need for a more formalized system of payments and settling international trade balances.

Lately, world reserve currencies or anchor currencies are currencies that are held in significant quantities by many governments, central banks, and institutions as part of their foreign exchange reserves (foreign assets). They also tend to be the international pricing currencies for products traded on a global market, and commodities such as oil, gold, coffee, etcetera. These currencies are, today, the US dollar (62.1 percent) and lately, its weak competitor the over-sweating euro (25 percent). The advantage for the issuing countries is that they can purchase the commodities at a marginally lower rate than the other nations, which must exchange their domestic currencies for the reserve currency with each purchase and pay a transaction cost too. For major currencies, this transaction cost is negligible with respect to the price of these commodities. These reserve currencies also permit the governments issuing the currencies to borrow money at a better rate, as there will always be a larger market for these currencies than the others. But, these world reserve currencies must be national currencies and not common currencies of diverse and unequal sovereign nations because their risk is higher, as the current euro experience proved to us.

Of course, reserve currencies come and go, as the size and power of different countries change over time. International currencies in the past have included, first, the Greek drachma and others with the passing of time. The word “nomisma,” meaning coin, as mentioned earlier, was used by Greeks; also, specialization, futures contracts, and many other terms used in economics, today, have Greek origin. According to Herodotus, money,² in the sense of coinage (drachmas), began to circulate in the Aegean in the early seventh century B.C. Xenophon (430–354 B.C.), a disciple of Socrates, is the “Father of Economics” (Oeconomicos).³ The other international currencies were the Chinese Liang, the silver punch-marked coins of fourth century B.C. in India, the Roman denari, the Byzantine solidus and the Islamic dinar of the Middle Ages, the Venetian ducato of the Renaissance, the Dutch guilder of the seventeenth century AD, and of course, more recently, the British sterling, the US dollar, and the novel euro.

Before 1944, the world reserve currency was the British pound sterling. After World War II, with the decline of the United Kingdom and the growth of the United States as a global power, the international financial system was governed for about three decades by a formal agreement, the Bretton Woods System. Under this system, the US dollar was placed deliberately as the anchor of the system, with the US government guaranteeing other central banks that they could sell their US dollar reserves at a fixed rate ($35/oz) for gold.⁴ During that period, European countries and Japan deliberately devalued their currencies against the dollar in order to boost exports and development (“beggar-thy-neighbor” policy). In the late 1960s and early 1970s, the system suffered setbacks due to problems pointed out by the Triffin dilemma,⁵ a general problem with any fiat currency⁶ under a fixed exchange rate regime, as the dollar was in the Bretton Woods system.

The US dollar is the most widely held currency in the allocated reserves, today. Throughout the last six decades, an average of two-thirds of the total allocated foreign exchange reserves of countries has been in US dollars. For this reason, the US dollar is said to have “reserve-currency status,” making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact or even postponing a currency crisis. Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. If non-US holders of dollar-denominated assets (China, Japan, OPEC nations, etc.) decide to shift holdings to assets denominated in other currencies, there could be serious consequences for the US economy. Changes of this kind are rare, and typically take place gradually over time; the markets involved adjust accordingly, too. However, the dollar remained until recently the favorite reserve currency because it has relative stability along with assets such as US Treasury securities that have scale, liquidity, and hopefully, no risk. This dominant position of the US dollar in global reserves is very much challenged currently, because of the growing share of unallocated reserves, and because of the doubts regarding dollar stability in the long term, due to the enormous debts incurred by the United States.⁷

Currently, the euro is the second most commonly held reserve currency, comprising a quarter of the allocated holdings. After World War II and the rebuilding of the German economy, the German Deutsche Mark gained the status of the second most important reserve currency (15.8% in 1995) after the US dollar. When the euro was launched, in electronic form on January 1, 1999, and in bank notes on January 1, 2002, replacing the Mark, French Frank, and seventeen other European currencies so far, it inherited the status of a major reserve currency from the Mark. Since then, its contribution to official reserves has risen continually (from 17.9 percent to 25.0 percent) as banks seek to diversify their reserves, as some nations have started mistrusting the US foreign policy, and as trade in the Euro-zone continues to expand. The euro could compete and might replace the US dollar as the world’s primary reserve currency. But the latest US-initiated worldwide credit crunch, its related recessions, and the Euro-zone sovereign debt crisis have had an adverse impact on the euro and will slow its adoption for many years, provided there are no bankruptcies in any Euro-zone nation.

Historically, for many centuries, the currencies of the world were backed by gold (“gold standard” and “gold exchange standard”). That is, a piece of paper currency issued by any world government represented a real amount of gold held in a vault by that government. In the 1930s, the United States set the value of the dollar at a single, unchanging level, which was 1 ounce of gold was worth $35. After World War II, with the Bretton Woods Agreement, other countries based the value of their currencies on the US dollar. Since everyone knew how much gold a US dollar was worth, the value of any other currency against the dollar could be based on its value in gold. A currency worth twice as much gold as a US dollar was, therefore, also worth two US dollars (i.e., e_t = 2$/FF). Unfortunately, the imbalances of the real world of economics outpaced this system. The US dollar suffered from inflation (its value relative to the goods it could purchase decreased), while other currencies became more valuable and more stable. Eventually, the United States could no longer pretend that the dollar was worth as much as it had been, and its value was officially reduced so that 1 ounce of gold was worth in the market for $70. Thus, the dollar’s value was cut in half. Finally, in 1971, the United States took away the gold exchange standard altogether. This meant that the dollar no longer represented an actual amount of a precious substance; market forces alone determined its value. Today, the US dollar still dominates many financial markets. In fact, exchange rates are often expressed in terms of US dollars. Currently, the US dollar (62.1 percent) and the euro (25 percent) account for approximately 87 percent of all currency exchange transactions in the world. Adding to the list, the British pound (3.9 percent), the Japanese yen (3.7 percent), the Swiss franc, the Canadian dollar, and the Australian dollar account for over 95 percent of currency exchanges altogether.

1.1 History of Currencies

A large proportion of the world aggregate demand (AD), about one-fifth, represents exports (X) and imports (M) among countries. The same amount represents also capital flows among nations because the current accounts (CA) are approximately equal to the capital accounts (KA), assuming official settlements (OS) zero [B of P = CA + KA + OS = 0]. In all these enormous transactions, there is a need for exchanging one currency for the other, so the relative price between two currencies plays a major role in this international economic and financial environment. International trade is as old as the political history of the nations on earth. In these early societies, the city-states exported and imported products among themselves and each one of them had its own currency. The currency exchanger had his bench (trapeza, banco, banca, banque = moneychanger’s table) in the middle of the marketplace (agora) and exchanged the different currencies with the local one for merchants to buy products they needed, like wine, oil, spices, food, and others. Thus, there was an exchange rate between these currencies that the “banker” (trapezitis) knew and used in these transactions.

Technological and technical advances followed the philosophical and social tenets practiced by these ancient nations (Hellenes, Egyptians, Assyrians, Sumerians, Babylonians, and others of those days). We see all these, today, from the archeological findings, their existing structures, and their literature. They were really advanced societies and, for this reason, we can say that their economic innovations were advanced too. The Greek philosopher Socrates had introduced many new (“kaina daimonia”) sociopolitical “innovations and beliefs,” and his student Xenophon introduced, as it was mentioned, a new science that he called “Oeconomicos,” the management of household (oecos = household and nemo = manage). These unique advances occurred 2,500 ago, but they led to lasting benefits for the entire world, and f...

Table of contents

• Cover
• Title
• 1 History of Exchange Rate
• 2 The Foreign Exchange Market
• 3 Foreign Exchange Rate Determination
• 4 Exchange Rate Forecasting
• 5 Foreign Currency Derivatives
• 6 Foreign Exchange Risk and Its Management
• Glossary
• Index