The Japanese Yen

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The Japanese yen is easily the most traded of Asian currencies and viewed by many as a proxy for the underlying strength of Japan’s manufacturing and export-driven economy. As Japan’s economy goes, so goes the yen (in some respects). Forex traders also watch the yen to gauge the overall health of the Pan-Pacific region as well, taking economies such as South Korea, Singapore, and Thailand into consideration, as those currencies are traded far less in the global forex markets.2

The yen is also well known in forex circles for its role in the carry trade (seeking to profit from the difference in interest rates between two currencies). The strategy involves borrowing the yen at next to no cost (due to low-interest rates) and using the borrowed money to invest in other higher-yielding currencies around the world, pocketing the rate differentials in the process.12

With the carry trade being such a large part of the yen’s presence on the international stage, the constant borrowing of the Japanese currency has made appreciation a difficult task. Though the yen still trades with the same fundamentals as any other currency, its relationship to international interest rates, especially with the more heavily traded currencies such as the U.S. dollar and the euro, is a large determinant of the yen’s value.

The Euro

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The euro has become the second most traded currency behind the U.S. dollar.2 The official currency of the majority of the nations within the eurozone, the euro was introduced to the world markets on Jan. 1, 1999, with banknotes and coinage entering circulation three years later.7

Along with being the official currency for most eurozone countries, many nations within Europe and Africa peg their currencies to the euro, for much the same reason that currencies are pegged to the U.S. dollar—to stabilize the exchange rate. As a result, the euro is also the world’s second-largest reserve currency.8

With the euro being a widely used and trusted currency, it is prevalent in the forex market and adds liquidity to any currency pair it trades with. The euro is commonly traded by speculators as a play on the general health of the eurozone and its member nations. Political events within the eurozone can also lead to large trading volumes in the euro, especially in relation to nations that saw their local interest rates fall dramatically at the time of the euro’s inception, notably Italy, Greece, Spain, and Portugal.910 The euro may be the most “politicized” currency actively traded in the forex market.

The U.S. Dollar is the dominant currency in foreign exchange markets. Measured by volume, the eight most common currency pairings involve the U.S. dollar

The U.S. Dollar

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The U.S. dollar, which is sometimes called the greenback, is first and foremost in the world of forex trading, as it is easily the most traded currency on the planet.2 The U.S. dollar can be found in a currency pair with all of the other major currencies and often acts as the intermediary in triangular currency transactions. This is because the greenback acts as the unofficial global reserve currency, held by nearly every central bank and institutional investment entity in the world.3

In addition, due to the U.S. dollar’s global acceptance, it is used by some countries as an official currency, in lieu of a local currency, a practice known as dollarization.4 The U.S. dollar also may be widely accepted in other nations, acting as an informal alternative form of payment, while those nations maintain their official local currency.

The U.S. dollar is also an important factor in the foreign exchange rate market for other currencies, where it may act as a benchmark or target rate for countries that choose to fix or peg their currencies to the dollar’s value. China, for instance, has long had its currency, the yuan or renminbi, pegged to the dollar, much to the disagreement of many economists and central bankers.5 Quite often, countries will fix their currencies to the U.S. dollar to stabilize their exchange rates rather than allowing the free (forex) markets to drive the currency’s relative value.

One other feature of the U.S. dollar is that it is used as the standard currency for most commodities, such as crude oil and precious metals. Thus, these commodities are subject not only to fluctuations in value due to the basic economic principles of supply and demand but also to the relative value of the U.S. dollar, with prices highly sensitive to inflation and U.S. interest rates, which can affect the dollar’s value

Real World Example of a Currency Board

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Hong Kong has a currency board that maintains a fixed exchange rate between the U.S. dollar and the Hong Kong dollar. Hong Kong’s currency board has a 100% reserve requirement, so all Hong Kong dollars are fully backed with U.S. dollars.1 While the currency board contributed to Hong Kong’s trade with the U.S., it also worsened the impact of the 1997 Asian financial crisis.

Disadvantages of a Currency Board

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Currency boards also have downsides. In fixed exchange-rate systems, currency boards don’t allow the government to set their interest rates. That means economic conditions in a foreign country usually determine interest rates. By pegging the domestic currency to a foreign currency, the currency board imports much of that foreign country’s monetary policy.

When two countries are at different points in the business cycle, a currency board can create serious issues. For example, suppose the central bank raises interest rates to restrain inflation during an expansion in the foreign country. The currency board transmits that rate hike to the domestic economy, regardless of local conditions. If the country with a currency board is already in a recession, the rate hike could make it even worse.

In a crisis, a currency board can cause even more damage. If investors offload their local currency quickly and at the same time, interest rates can rise fast. That compromises the ability of banks to maintain legally required reserves and appropriate liquidity levels.

Such a banking crisis can get worse fast because currency boards cannot act as a lender of last resort. In the event of a banking panic, a currency board cannot lend money to banks in a meaningful way.

Advantages of a Currency Board

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Currency board regimes are often praised for their relative stability and rule-based nature. Currency boards offer stable exchange rates, which promote trade and investment. Their discipline restricts government actions. Wasteful or irresponsible governments cannot simply print money to pay down deficits. Currency boards are known for keeping inflation under control.

Currency Boards vs. Central Banks

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Like most of the world’s large economies, the U.S. does not have a currency board. In the United States, the Federal Reserve is a true central bank, which operates as a lender of last resort. The exchange rate is allowed to float and determined by market forces, as well as the Fed’s monetary policies.

By contrast, currency boards are somewhat limited in their power. They mostly just hold the required percentage of pegged currency that was previously mandated. They also exchange local currency for the pegged (or anchor) currency, which is typically the U.S. dollar or the euro.

A currency board has less power to harm or help the economy than a central bank.

How a Currency Board Works

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Under a currency board, the management of the exchange rate and money supply are given to a monetary authority that makes decisions about the valuation of a nation’s currency. Often, this monetary authority has direct instructions to back all units of domestic currency in circulation with foreign currency. When all domestic currency is backed with foreign currency, it is called a 100% reserve requirement. With a 100% reserve requirement, a currency board operates similarly to a strong version of the gold standard.

The currency board allows for the unlimited exchange of the domestic currency for foreign currency. A conventional central bank can print money at will, but a currency board must back additional units of currency with foreign currency. A currency board earns interest from foreign reserves, so domestic interest rates usually mimic the prevailing rates in the foreign currency.

What Is a Currency Board?

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A currency board is an extreme form of a pegged exchange rate. Management of the exchange rate and the money supply are taken away from the nation’s central bank, if it has one. In addition to a fixed exchange rate, a currency board is also generally required to maintain reserves of the underlying foreign currency.

KEY TAKEAWAYS

  • A currency board is an extreme form of a pegged exchange rate.
  • Often, this monetary authority has direct instructions to back all units of domestic currency in circulation with foreign currency.
  • Currency boards offer stable exchange rates, which promote trade and investment.
  • In a crisis, a currency board can cause substantial damage by restricting monetary policy.

Pros and Cons of a Weak Currency

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A weak currency may help a country’s exports gain market share when its goods are less expensive compared to goods priced in stronger currencies. The increase in sales may boost economic growth and jobs while increasing profits for companies conducting business in foreign markets. For example, when purchasing American-made items becomes less expensive than buying from other countries, American exports tend to increase. In contrast, when the value of a dollar strengthens against other currencies, exporters face greater challenges selling American-made products overseas.

Currency strength or weakness can be self-correcting. Because more of a weak currency is needed when buying the same amount of goods priced in a stronger currency, inflation will climb as nations import goods from countries with stronger currencies. Eventually, the currency discount may spur more exports and improve the domestic economy, provided there are no systematic issues weakening the currency.

In contrast, low economic growth may result in deflation and become a bigger risk for some countries. When consumers begin expecting regular price declines, they may postpone spending, and businesses may delay investing. A self-perpetuating cycle of slowing economic activity begins and that will eventually impact the economic fundamentals supporting the stronger currency