Refers to a method of payment in exchange for goods and services.
Currency is a method of payment in exchange for goods and services. In more common words, it's money. Money is issued by governments and accepted by the community as a medium of exchange.
Each country has its currency, and each currency has a distinct value. However, different economic situations and government decisions affect the state of the currency as a weak or hard currency.
Hard currency, also known as haven currency or strong currency, refers to money that is globally regarded as economically and politically stable.
These currencies are internationally accepted as a payment in exchange for goods and services and may be considered superior to the local currency.
Strong currencies maintain their power and high status concerning the nation's legal and official institutions, degree of corruption, purchasing power, and the systems of central banks.
On the other hand, soft currencies are prone to fluctuation and devaluation. The weaknesses of such currencies are due to their countries' fragile legal and political systems.
Hard currencies are expected to be stable for at least a short period and liquid in the foreign exchange market (also known as forex or FX).
The forex market is an international electronic marketplace for trading global currencies and currency derivatives. Despite the intangible existence of the forex market, it is one of the largest by trading volume, accounting for trillions of dollars of exchanges daily.
The most popular and trusted currencies around the world are:
- U.S.dollar (USD)
- European euro (EUR)
- Japanese yen (JPY)
- British pound (GBP)
- Swiss franc (CHF)
- The Canadian dollar (CAD)
- Australian dollar (AUD)
*These currencies are trusted by investors and relied upon for international trading since they are not subject to volatility and depreciation.
The Bretton Woods System and the Rise of the U.S. dollar
The U.S.dollar is the perfect example of a hard currency. Most of the world's financial systems are bound to the U.S.dollar due to the now defunct Bretton Woods system.
Back in 1944, representatives from 44 nations met in Bretton Woods, New Hampshire. The meeting's purpose was to agree on an international monetary system that later was called the Bretton Woods system.
This system had many goals to achieve, such as:
- Stabilize exchange rates
- Shut out competitive devaluations
- Boost economic growth
It sounds like a promising event, right? Let's find out.
The Bretton Woods system became fully functional in 1958. Countries agreed to settle their global accounts in dollars that can be exchanged for gold at a fixed exchange rate of $35 per ounce of gold, which, of course, was redeemable by the U.S. government.
Therefore, the U.S. provided gold overseas, and other currencies were attached to the dollar.
At first, the system seemed to be working fine. But, by the end of the second world war, Europe and Japan were restructuring from the ashes of the war, and other countries demanded dollars to get their hands on U.S. machinery and tools.
Additionally, the U.S. held more than half of the world's gold reserves at the time, so things were going well.
However, from 1950 to 1969, Japan and Germany showed signs of recovery, leading to a decrease in the U.S.' share of the global output from 35% to 27%.
Moreover, the consequences of the Vietnam War, monetary inflation, increased public debt, and a negative balance of payments made the U.S. dollar enormously overvalued by the 1960s.
By 1971, Germany decided to leave the Bretton Woods system to avoid revaluing the Deutsche Mark. This was a massive booster for the German economy. However, it also caused the dollar to drop by 7.5% against the German Mark. Later, other nations started to redeem their dollars for gold.
This led to the United States Congress releasing a report on August 5, 1971, recommending the dollar's devaluation. Four days later, Switzerland left the Bretton woods system as the dollar dropped more in value against European currencies, increasing the pressure on the U.S. to leave the system.
The U.S. Dollar Today
Thanks to the Bretton Woods system, the U.S. dollar officially became the world's reserve currency, backed by the largest gold reserves in the world.
Rather than holding gold, countries started holding U.S. dollars. Not only that, but governments also started buying U.S. treasury securities to store their dollars safely.
During the Vietnam war, the United States spent massive amounts of money, flooding the market with dollars. This caused other countries to doubt the U.S. dollar's stability and began converting their dollar reserves into gold.
President Nixon decided to de-link the dollar from gold, leading to today's floating exchange rates. However, the U.S. dollar remained the world's reserve currency despite stagflation.
During the fourth quarter of 2020, central banks held more than 59% of their reserves in U.S. dollars, according to the International Monetary Fund (IMF). The reserves are stored in cash or U.S. bonds; most external debt is dollar-denominated.
The U.S. holds the status of the most traded currency in the world due to the strength of the U.S. economy and its superiority in the financial markets.
Even though the United States has a large spending deficit, trillions of dollars in debt, and unconstrained printing of U.S. dollars, U.S. securities remain the safest investment.
The confidence that the globe has in the ability of the United States to pay its debts allows the dollar to maintain its status as the most traded currency in the world.
*Despite all these impressive facts and records, the U.S. dollar is only 10th on the list of the strongest currencies in the world, according to CMC Markets. On the other hand, the Kuwaiti dinar, backed by oil reserves, was named the strongest currency in the world.
What Makes a Strong Currency?
A strong currency can sometimes mean the country is economically fine and healthy. When the currency is strong, it signifies high economic growth, low unemployment, and rising productivity.
Countries can follow different policies to strengthen their currency, such as:
- Buying domestic currency and selling foreign exchange assets
- High-interest rates
- Low inflation
1. Buying domestic currency and selling foreign exchange assets
Countries with a significant surplus of foreign assets can follow a strategy to appreciate their currencies. For instance, China has over $1.4 trillion of U.S. government bonds.
If they sell these bonds and purchase their currency, the value of the Chinese yuan will increase relative to the dollar. However, since they own a significant amount of U.S. assets, they can significantly depreciate the dollar's value.
However, China has intentionally used its foreign currency earnings to buy U.S. assets to depreciate its currency and make its exports more competitive.
Countries with small accounts of U.S. assets would be unable to have a massive effect on the dollar's value.
2. High-interest rates
When interest rates in a country are high, hot money flows will be attracted. Hot money flows are when banks and other financial institutions transfer their money to other countries to gain higher returns.
Nevertheless, higher interest rates may have drawbacks in terms of economic growth. This is because it may lead to less domestic spending and investment. However, when interest rates are high, the currency can appreciate moderate economic growth.
Countries aiming for higher exchange rates are not that common. For example, Switzerland has once considered a "haven" country, causing increased demand for the Swiss franc.
However, the Swiss government and central bank were anxious that such appreciation might harm exporters. Yet, if the country gave an explicit guarantee that they were aiming for higher exchange rates, investors would have gladly placed their money in the country.
4. Low inflation
When inflation rates are low relative to competitors, a county's goods will be more attractive and demanded. Therefore, maintaining that level of competitiveness and low inflation will lead to the currency's appreciation in the long term.
Countries have been fighting for a weaker currency to encourage export competitiveness. However, having a strong currency could provide an upper hand too.
Strong currency advantages are and are not limited to:
- Lower inflation
- Lower costs for exporters
- Acquisition options
- The luxurious quality of life
Strong currencies help reduce the cost of imported goods, lowering consumer prices. This is because many products require raw materials that aren't found in every country.
Each country will have to import some of these raw materials. When the prices of imported materials increase, the overall production costs will also increase.
Let's elaborate on the situation with the Lebanese scenario.
Lebanon has been going through massive hyperinflation since 2019, when the revolution began, demanding better living conditions. When these events started, the Lebanese pound devalued significantly.
Before the revolution started, 1500 Lebanese pounds were equivalent to $1. However, in 2022, the Lebanese pound is fluctuating without a constant price, somewhere between 20-30k Lebanese pounds per $1.
A product that used to cost 750 LBP now costs about 18,000 LBP
Employees' salaries are still paid in Lebanese pounds, and the living conditions are even harder to describe.
*Strengthening domestic currency and maintaining strength helps to avoid falling into the trap of such massive price increases or simply reducing inflation.
Lower costs for exporters
Having a strong currency means exported goods are less competitive. However, as compensation, a strong currency reduces the prices of raw materials imported from different countries, making exporters pay less for such materials and reducing the overall costs.
A company from a country with a hard currency can have the option to acquire a similar company or supplier in another country with a weaker currency. This enables the company to use lower costs using a stable currency.
People living in countries with stable currencies can enjoy cheaper vacations abroad. For example, suppose you are living in the U.S. and making thousands of dollars, and you decide to visit a country with a weak currency.
The exchange rates of the dollar will be significantly higher, and the overall expenses of the vacation will be low compared to countries with a strong currency.
Again, a vacation of $1000 to Lebanon, for example, would be the trip of a lifetime for foreigners, as they can enjoy the beautiful sites in Lebanon with relatively small expenses.
Could you go on a vacation to Europe for $1000? Unfortunately, it wouldn't be that easy.
1. The fall in domestic demand
Currency appreciation may result in a fall in domestic demand. When the currency is strong, exports are less competitive, and imports are cheap. If this is the case for a slowly growing economy, then a strong currency will be a curse rather than a blessing.
2. Current account deficit
A strong currency could lead to the collapse of current accounts. For example, from 2002 to 2012, major European countries faced a massive current account deficit due to a strong currency that made their exports relatively uncompetitive.
Of course, they couldn't allow for the depreciation of the currency. So, all the while, trade deficits grew.
*Spain, Portugal, and Greece all experienced record trade deficits.
However, having a strong currency doesn't necessarily lead to such consequences. It depends on multiple factors such as:
3. The reason behind a strong currency
Suppose the currency is strong because of economic fundamentals such as high employment, low inflation, and strong growth. In that case, the currency's strength is promising for the country, as the currency will be well-valued and compensate for the loss of the exports' competitiveness.
However, currency can be substantial simply because of speculation. In the case of the Swiss franc, for example, it became overvalued since its currency's strength was not influenced by economic fundamentals but rather by prominent speculative positions.
Their exports became uncompetitive, and they faced a fall in domestic demand.
4. The timing of a strong currency
When a country faces an economic boom causing inflation, the currency's appreciation could be beneficial since it would help maintain a steady growth rate.
When facing an economic recession, a strong currency can deepen the recession, decreasing domestic demand. This is mainly an issue for countries in the eurozone.
For instance, the euro's value is more than Greece can afford. Their current trade deficit is about 10% of the growth domestic product (GDP). Yet, Greece can't take effective policies to devalue the euro.
As a result, a strong currency leads to negative consequences for economic growth, causing deflation.
- Hard currency refers to trusted currencies used in international trading, backed by economic and political stability.
- Soft currencies devaluate due to corrupt and failed legal and financial systems.
- Thanks to the Bretton Woods system and the confidence the world has in the U.S.' ability to pay its debts, the U.S. dollar is the most traded currency in the world.
- Despite the popularity of the U.S. dollar, the Kuwaiti Dinar was named the world's strongest currency.
- Buying domestic currency and selling foreign exchange assets, low inflation, high-interest rates, and projections can all lead to the appreciation of the domestic currency.
- Strong currency grants a nation multiple advantages, such as low inflation, low costs for exporters, acquisition opportunities, and luxurious lives for the locals.
- Despite the many advantages of a strong currency, it also has some drawbacks, such as the fall in domestic demand and an increased trade deficit.
A strong currency is beneficial for those traveling abroad and consumers who like to buy imported products, as they will be cheaper
Suppose economic fundamentals back the strength of the currency.
In that case, the appreciation of the currency will compensate for the loss of exported goods' competitiveness by providing lower inflation, lower costs, acquisition opportunities for companies, and luxurious lives for locals.
A strong currency doesn't necessarily mean a strong economy as it is mainly caused by trade performance, capital inflows, or a central bank.
The U.S. dollar is backed by the confidence the world has in the United States to pay back its debts, a strong GDP, and a significant presence in the financial markets.
Everything You Need To Master Financial Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
Researched and authored by Kassim Faour | Linkedin
Reviewed and edited by James Fazeli-Sinaki | LinkedIn
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