THE EMERGENCE OF A FOREIGN EXCHANGE MARKET

The reemergence of currency as a medium for facilitating business can be traced back to Frisian and Anglo Saxon traders from around 700 CE. Small, thick silver coins (deniers) were minted on both sides of the North Sea from around this time and have been found scattered along the Frankish trade routes into Frisia.¹ However, even then it was clear that the money produced in different regions would also have different values. In Aquitaine, for example, Frisian coins were much preferred to the debased money coming from what is now France.² By the reign of England's Henry VII (1457–1509) the need for traders to exchange one currency for another had grown so strong that a currency exchange was established within Leadenhall market in London. Indeed, Henry VII is recorded as having speculated on the European currency markets himself, using his favored broker, the Bolognese financier Lodovico della Fava, to carry out the trades.³

The need to exchange one currency for another is therefore almost as old as the emergence of money as a medium for trade. However, in order to exchange one currency for another there needs to be a price at which the deal can be fixed. This is the exchange rate.

THE MECHANISM

Although an exchange rate can in some instances be for a transaction that settles on the same day, within the modern currency markets the normal convention is that the deal will settle in two banking days in order to allow for the smooth processing of the trade. This agreement to exchange the currencies at an agreed price as soon as is practical (on the spot) is known as a spot transaction or (in the terminology of the currency markets) spot.

It may be the case that an investor does not wish to buy or sell one currency outright against another but, instead, simply wants to borrow one currency against another over a specific period of time. There are many reasons why this might be the case. One of the most common is that the investor wants to buy a local security (for example, a share in a company) but doesn't want to be exposed to fluctuations in the value of the underlying currency. The mechanism for this is a foreign exchange swap. In a swap the participants agree to exchange currencies on the start date of the transaction at an agreed price (normally the spot price at the time) and then swap them back at the end of the agreed period at a price that has been adjusted to take into account the relative interest rates of the two currencies in question.

It may also be the case that a company does wish to purchase (or sell) a specific currency but does not need the money immediately. It could be, for example, that an exporter knows that it will receive a known payment in a foreign currency in three months but wishes to fix the price now in order to remove any uncertainty. This is achieved by simply combining a spot transaction together with a foreign exchange swap to create what is known as a forward transaction.

WHO USES THE FOREIGN EXCHANGE MARKET?

Almost everyone will need to buy or sell a foreign currency at some point in their lives, even if it is just to have some spending money while on a vacation abroad. Any company that exports goods or services will also need to be able to convert their earnings from overseas back into their home currency while those firms that import, for example, commodities from overseas will need to buy foreign currency in order to be able to pay for what they have bought. Governments and supranational organizations may also regularly need to use the foreign exchange markets in order to be able to make aid payments or make contributions to other organizations.

Since the late 1980s investment firms have become increasingly important players in the foreign exchange markets as they have looked to diversify their investment portfolios internationally. These investments can stretch from the largest markets (such as Japan) to some of the newest (in Africa, for example). These have been joined in recent years by the managers of the foreign exchange reserves of a wide number of nations (reflecting the phenomenal growth in currency reserves since 2002).

WHAT ARE THE MAIN CURRENCIES?

Although a few countries (e.g., Panama) simply use another nation's currency instead of having their own, this brings with it some unique problems. In particular, it means that the local authorities have no control over the setting of official interest rates as this will effectively be done by the central bank of the nation issuing the currency. As a result the government could, for example, find itself having to cope with higher interest rates at a time the nation may be facing a recession. Therefore, most nations prefer to have their own currency.

There is one major exception to this. At the beginning of 1999, 11 members of the European Union adopted the euro as their official currency. Since then a further 8 members of the European Union have joined the currency (it is the second most widely traded currency in the world). The European Central Bank (ECB), which is governed by a president and a board of the heads of national central banks, sets the monetary policy of the area. However, significant problems have emerged in the euro area is recent years. In particular it has become apparent that a one‐size‐fits‐all monetary policy can lead to significant economic imbalances in the absence of a region‐wide fiscal policy to act as a counterbalance. As a result a number of nations experienced significant booms (often in the housing market) in the early years of this century followed very rapidly by crippling busts.

The most widely traded currency in the world (according the Bank of International Settlements April 2013 triennial central bank survey) is the U.S. dollar. Other widely traded national currencies include the Japanese yen, the UK's pound, the Australian dollar, Swiss franc, Canadian dollar, Mexican peso, Chinese yuan, and New Zealand dollar. Other significantly traded national currencies include the Swedish krona, Russian rouble, Hong Kong dollar, Norwegian krone, Singapore dollar, Turkish lira, South Korean won, South African rand, Brazilian real, and Indian rupee.

EXCHANGE RATE REGIMES

There have been over time (and still remain) different types of regimes under which the exchange rates are managed. Following a meeting in Bretton Woods, New Hampshire, in 1944 a system sometimes described as a “gold exchange standard” was established that became operational in 1945. The chief feature of the system was an obligation for each country to maintain its exchange rate within a defined band (either plus or minus 1%) against the U.S. dollar. Should the currency move outside this band, then members were expected to take appropriate action either by moving official interest rates or by intervening directly in the currency markets to buy or sell. Meanwhile the United States agreed to link the dollar to gold at the rate of $35 an ounce. However, this system began to come under increasing pressure in the second half of the 1960s as high fiscal spending by the U.S. administration took its toll on confidence. With investors buying increasing amounts of gold at the fixed price on offer it was only a matter of time before the system collapsed. This came in August 1971 when President Nixon announced (without having consulted with other members of the international monetary system) that the United States had “closed the gold window.” This meant that gold could no longer be bought at a fixed price of $35 per ounce but, instead, at a rate determined on the open market. Despite further attempts to redesign the exchange rate system (in particular the Smithsonian Agreement of December 1971) the writing was on the wall for the Bretton Woods system. After a 10% devaluation of the U.S. dollar in February 1973, Japan along with members of the European Economic Community decided to allow their currencies to free float. This meant that their value was set on the open market with prices being driven by shifting supply and demand.

There have been subsequent attempts to manage groups of currencies within defined price ranges (or bands), most notably the European Exchange Rate Mechanism. For such a system to work each nation must essentially keep their official interest rates at the same level. If not, investors will simply move all their money to the nation with the highest interest rates, leaving all the other members of the system having to struggle as their local economy collapses. However, varying economic circumstances over time typically mean that at some point one member or another of the system will need to shift interest rates relative to its neighbors. Once it becomes apparent that this is the case, then money will begin to flow either in or out of the currency (dependent on whether the market believes interest rates are going up or down), forcing the local authorities either to defend their currency or to step aside and allow the currency to break outside of the band. These systems have rarely fared well.

Attempts either to keep currencies at a pegged exchange rate against another currency (a fixed exchange rate system) or to heavily manage their value (dirty floats) have also created their fair share of problems over time. One of the key issues for many of the nations impacted by the Asian crisis during 1997 and 1998 was that they found themselves running critically low of FX reserves with which to protect their currencies, forcing them instead to turn to the IMF for help. As a result these nations became keen to keep their currencies competitive in order to rebuild their economies through export growth as well as to build sufficiently large FX reserves to provide a buffer against any future crisis.

By the early part of the next decade the United States had become increasingly critical of Chinese and Japanese currency policies, seeing them as being deliberately designed to keep their currencies artificially weak in order to gain a mercantile advantage. While U.S. officials would probably deny they decided to fight fire with fire, to some outside observers it appeared that at some point in 2001–2002 they adopted a policy of benign neglect toward the U.S. dollar, driven by increasingly low interest rates (relative to inflation). It was the response of the emerging‐market nations to this weakening of the U.S. dollar, however, that mattered the most over the long term. In particular, the wave of money coming out of the United States presented the opportunity they were looking for to rapidly build their reserves in order to ensure that they need never find themselves again in the situation they were in during the late 1990s. Moreover, while Asia might have been where the conflict reignited, the post–2001 boom in currency reserves was not limited to the region. Across the emerging and developing world FX reserves grew from $801 billion at the end of 2001⁴ to stand at $5.373 trillion by the end of 2009 (i.e., just before the start of the Eurozone crisis). By the summer of 2014 this number had expanded further to reach just over $8 trillion.

Three main problems presented themselves to these nations. The first was that the inflows of “hot money” were so substantial and so rapid that the local authorities often struggled to stop their currencies appreciating to what they considered uncompetitive levels (particularly against their regional competitors). As just one example of how overwhelming (and indiscriminate) these flows could be, the Bank of Thailand found itself having to intervene in its local currency markets in late October 2006 in order to slow the appreciation of the Thai baht. What was extraordinary about this was that it came just over a month after a coup d'état had led the bank to temporarily suspend trading in the currency for fear of potential outflows.

The second problem was that the outflows, when they came, could be equally brutal. In the latter stages of 2014 the Central Bank of Russia found itself trying to defend the ruble's managed exchange rate system in the face of significant outflows as the price of oil (one of its major export commodities) collapsed. Having seen its gold and FX reserves fall by $83 billion since the start of that year (around a 16% decline) the central bank announced that the ruble would float freely (adding in a statement that it would intervene in the FX market at any moment with sufficient volumes to cut speculative demand).

The third problem facing these nations was what to do with the foreign exchange reserves they had accumulated. This was a particular problem for China, which by late 2013 had seen the value of its reserves soar to close to $4 trillion. By October of that year it was clear that the weight of opinion in China was moving toward adopting a policy that allowed it to stop accumulating fresh foreign exchange reserves. In an opinion piece for the Financial Times, Professor David Li, a former policy advisor to the People's Bank of China (PBoC) and a prominent economist at Tsinghua University, questioned China's levels of exposure to the U.S. Treasury market (around $1.28 trillion at the time) and the argument that this was because of a lack of alternative investments. He argued instead that the State Administration for Foreign Exchange (SAFE) should invest in the shares of multinationals operating in the Chinese market, increase the holdings of all non‐U.S. sovereign bonds rated higher than double‐A‐plus, as well as buying the shares of public utility companies in mature market economies. Professor Li added that the only explanation of why China had yet to reduce its exposure came down to China's relationship with the United States, noting that the Treasury holding represented “both a hostage scenario and a bonding instrument for the two largest economies in the world.” He concluded by saying: “We do not know how long long‐term political logic can prevail over the economic rationale.”⁵

The policy shift itself came in November 2013 at the Third Plenum (the Communist Party's once‐a‐decade economic planning forum). Summarizing the forum, the Wall Street Journal stated on November 13, 2013, that China would relax investment controls and allow the market to play a “decisive” role in allocating resources. Two days later the Xinhua News Agency stated specifically that the acceleration of Chinese renminbi convertibility and liberalization of interest rates were among the key reform proposals decided on (although it also noted that the party said it planned to achieve these targets by 2020).

If there were any doubts about China's view on continued reserve accumulation, these were dispelled by the comments on November 21, 2013, by Yi Gang, deputy governor of PBoC and head of SAFE. He stated that while ample foreign reserves helped China defend against the impact from external speculation, the marginal costs of accumulating foreign reserve had now exceeded the marginal gains, which was therefore not good for China's development. This point was expanded upon on June 12, 2014, when Huang Guobo (the chief economist of SAFE), said in a webcast: “The excessively large foreign exchange reserves increase domestic money supply and create potential domestic inflation pressures. They also put more pressure on the central bank to raise reserve requirement ratios and sterilize (inflows).” He added that foreign currency reserves accounted for more than 80% of the central bank's assets, leading to a mismatch between its assets and liabilities, fueling foreign exchange risks.

Some exchange rate systems have proved durable over time. Hong Kong has run a currency board (the Hong Kong Monetary Authority or HKMA) since October 1983. Under this system the HKMA authorizes note‐issuing banks in the Special Administrative region to issue bank notes. These banks in turn are required to hold U.S. dollars to the equivalent value of the notes they have issued (using an internal fixed exchange rate of 7.8 Hong Kong dollars to every 1 U.S. dollar). While this system has come under pressure a number of times since it was established, it has yet to be broken due to the simple fact that the Hong Kong dollar is by definition fully backed by the U.S. dollar. Nevertheless, this system has brought its own set of problems. In particular, Hong Kong interest rates must track those of the United States irrespective of the needs of the local economy.

THE SIZE OF THE FOREIGN EXCHANGE MARKET

While the mechanisms underlying the foreign exchange market are remarkably simple, the fundamental need for individuals, manufacturing companies, and investment firms (along with governments and supranational organizations) to buy and sell (or borrow and lend) currencies ensures that it has become the largest in the world. According to the Bank of International Settlements triennial central bank survey, trading foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. Little wonder then that governments continue to try to manage their exchange rates or that the scale of the forces at play often means they fail in their efforts.

THE FUTURE OF THE FOREIGN EXCHANGE MARKET

The varying economic and political circumstances of different nations and economic regions means that they each have varying monetary and fiscal policy needs. Having a sovereign currency allows these nations to implement these policies with the minimum amount of disruption. As long as this remains the case there will also need to be a price at which one currency can be exchanged for another (the exchange rate). However, it is also clear that there is still little unity as to how these exchange rates should be fixed. Those that have turned their back on floating exchange rates have suffered over time from sharp inflows and outflows of hot money and have often had to contend with interest rates that are simply not suited to their domestic needs. At the opposite extreme those nations that have adopted free‐floating exchange rates have increasingly found themselves in political battles with nations they suspected of manipulating their currencies.

Perhaps the most radical experiment has been the decisions of the 17 nations of the euro‐area to adopt a common currency. While not the first time that a currency union has been created, this was still a bold rejection of free‐floating exchange rates. For the moment the jury remains very much out on whether this experiment can succeed in its current form.

Even if Europe's currency union were to prove successful economically, membership still brings potential problems that would not be faced by those nations with their own currencies. In particular, there remains the question over what would happen should a member nation decide to leave the European Union (the underlying political construct). Some idea of the potential problems that this might pose can be seen by considering the referendum held in the United Kingdom in June 2016 on membership of the European Union. Although the vote by the electorate to leave the EU may well pose significant economic problems for the UK, one issue it will not have to face is what currency it will need to use in the future as it already uses the pound sterling. In contrast, should a user of the euro decide to hold a similar referendum and find that the electorate voted to leave the European Union, then they would face the difficult choice of either reintroducing their own currency or continuing to use the euro but relinquishing any say whatsoever in the policies pursued by the European Central Bank. Either choice would present significant problems for the nation in question.

Europe probably provides the clearest example as to why exchange rates and the way they are set remain such a politically emotive topic. Over 40 years after the failure of the Bretton Woods system, calls still surface on a regular basis for the creation of an updated version of the system. However, the evidence from the past four decades indicates that while it might be flawed, a system of free‐floating exchange rates remains the most effective way of determining the price of one currency against another.