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Currency Markets

Major International Currencies

In this unit, we will discuss a few major currencies that are known internationally:

 

INR:

 

Indian Rupee (INR) trades against US Dollar (USD) under the managed floating exchange rate regime. This means that though the Indian rupee has a market-determined exchange rate, the Reserve Bank of India (RBI) trades actively in the INR/USD currency market to impact effective exchange rates. A managed or dirty float is a currency regime for an Indian rupee for the US dollar. RBI intervenes in the currency markets only for ensuring there is low volatility in exchange rates and doesn't take a view on the direction of the Indian rupee concerning other currencies. 

 

INR is fully convertible on India’s current account, but not on the capital account except for certain transactions carried out by foreign institutional investors who can fully repatriate their investments.

 

Indian companies have also been permitted to invest, up to 400% of its net worth of $1 billion, in shares of foreign companies; Mutual Funds are permitted to invest in ADRs/GDRs of the Indian companies, rated debt instruments also invest in equity of overseas companies with an overall cap of $1 billion.

 

Furthermore, under the Liberalized Remittance Scheme of $250,000 resident individuals are free to hold and acquire shares, immovable property, or any other asset outside India without prior approval of RBI, enabling them to convert their rupee-denominated assets into foreign currency denominated assets. These are steps closer to the full convertibility of the rupee.

 

All of these measures can have an impact on the exchange rate of ₹ as well as the forward premium of $/₹ and developments on these fronts are noticed by corporate hedgers, traders, etc. active in the Indian foreign exchange market.

 

On 29th August 2008, the National Stock Exchange of India launched the much-awaited currency futures market in India. This is a crucial event in the Indian financial market as resident Indians such as SMEs with exposure to dollar risk, students, outbound tourists, and patients planning to travel abroad for treatment can hedge their foreign currency risks through this instrument. So far there have only been bilateral currency futures contracts over-the-counter trades, but with the commencement of currency trade on the exchanges, the process becomes much more transparent.

 

US Dollar:

 

At present, the U.S.D remains the world's foremost reserve currency. The majority of U.S. notes are held outside the United States as reserves. The holdings of the US dollar bank's deposits which are held by the non-residents of its currency is known as Eurodollars. The United States can maintain its trade deficits without causing its currency to depreciate and the flow of their trade to readjust because of the overseas demand for the dollar. However, more recently, after large-scale bailouts in the current financial crisis, Paul Samuelson has said he now believes that at some stage in the future these pressures will precipitate a run against the U.S. dollar with serious global financial consequences.

 

The following chart illustrates the dominance of the USD in the World Economies:

 

Source: Wikipedia

 

Dollarization:

 

Nations other than the United States also use the dollar as their official currency, this process is known as dollarization. For example, Panama uses the dollar alongside the Panamanian balboa as their legal tender since 1904 at a 1:1 conversion rate. Ecuador, El Salvador, and East Timor adopted the USD independently. 2 British dependencies also use the U.S. dollar: 1) the British Virgin Islands and, 2) the Turks and Caicos Islands.  

 

Other countries also link their currency to the U.S. dollar at fixed exchange rates. The local currencies of Bahamas and Bermuda can be freely exchanged at a ratio of 1:1 USD. Argentina used a fixed 1:1 exchange rate between the U.S. dollar and Argentine peso from 1991 until 2002. The currencies of Belize and Barbados are convertible at an approximate 2:1 ratio. In Lebanon, $1 is equal to 1509.69 Lebanese pounds and is used to interchange with the local currency as de facto legal tender. Since 1983, the exchange rate between the Hong Kong dollar (HKD) and USD has been linked at 7.8 HKD/USD, and Pataca of Macau is linked indirectly to the U.S. dollar at roughly MOP8/USD. Several oil-producing Arab countries on the Persian Gulf, including Saudi Arabia, peg their currencies to the dollar because the dollar is the currency that is used for international oil trades.

 

USD because of its strong pedigree and influence on global economics is a very important indicator to be followed for any local currency movements. The tracking of a dollar can be done through Dollar Index. 

 

US Dollar Index:

 

The U.S. Dollar Index (USDX) is created by the New York Board of Trade (NYBOT). It was established in 1973 for tracking the value of the USD against other currencies, which, at that time, signified the largest trading partners of the U.S. It began with 17 currencies of 17 nations, but the launch of the euro joined 12 of these into one. So, the USDX tracks 6 currencies currently, including the euro. After ICE took over the NYBOT exchange, this index is now a part of the ICE trading platform. Following is the composition of the Dollar Index.

 

 

Euro:

 

The Euro (€) is the official currency of the European Union's (EU) 16 of the 27 member states. The states, known collectively as the Eurozone, are Belgium, Cyprus, Greece, Finland, France, Germany, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Austria, and Spain. The currency is also used in another 5 European countries, both with and without formal agreements.

 

The euro has more than €1.3 trillion in circulation as of Dec. 2019. The euro has the highest combined value of cash in circulation in the world, surpassing the U.S. dollar. Based on the estimates of 2019 GDP and purchasing power parity among the various currencies, the European Union is the 2nd largest economy in the world.

 

Since its introduction, the euro has been the 2nd most widely-held international reserve currency after the U.S. dollar. The share of the euro as a reserve currency has increased from 17.9% in 1999 to 20.67% in 2020. The euro becoming the first international reserve currency has now a real chance. Former Federal Reserve Chairman Alan Greenspan gave his opinion in September 2007 that it is "absolutely conceivable that the euro will replace the dollar as a reserve currency, or will be traded as an equally important reserve currency."

 

Euro is a highly volatile currency, particularly with USD. The ECB targets interest rates rather than exchange rates and, in general, it does not intervene in the foreign exchange rate markets, because of the implications of the Mundell-Fleming Model. This model suggests that a central bank cannot maintain the exchange rate and interest rate targets simultaneously because increasing the money supply results in a depreciation of its currency.

 

After the Single European Act, the EU has liberalized its capital markets, the ECB has been chosen as a monetary autonomy, the exchange rate regime of the euro is flexible, or floating. This explains why the exchange rate of the euro against other currencies is seen by strong fluctuations. Most notable are the fluctuations of the Euro v/s the U.S. dollar. However, this focus on the dollar-euro parity is subjective. This is a subjective reference because the euro competes with the dollar, as a reserve currency. This reference has a misleading effect because it gives observers an impression that a rise in the value of the euro against the dollar is the effect of the increased global strength of the euro, but actually, it is the effect of an intrinsic weakening of the dollar itself.

 

On 22nd Jan. 2015, the euro fell to $1.12. This happened because the ECB announced that they will purchase 60 billion in euro-denominated bonds each month starting in March. This method of quantitative easing gave a boost to the EU's economy, which had been struggling with a recession. 

 

On 2nd Jan 2019, the euro was valued at $1.14. It started to fall throughout the year because the investors preferred the U.S. dollar because they were concerned about the decline of global trade due to former President Trump's trade war. By August 16, the euro fell to $1.11.

 

Yen:

The Yen (sign: ¥; code: JPY) is the only currency of Japan. JPY is one of the most traded currencies in the world and is widely used as a reserve currency. Yen is also considered the principal source of funds for global markets. The high savings rate and low-interest rates in Japan prompt the Japanese investors to park surplus Yen funds in international assets.  

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