What do we mean by currency, how do currencies work and how can they affect UK and international economics?
Few of us think about currency in our everyday lives. If we do, it’s usually in the context of trying to second-guess the best time to buy US dollars, euros or Turkish liras for our holidays. But changes to the relative values of currencies can have far-reaching effects beyond how cheap or expensive our next holiday is likely to be.
In this focus article we look at what we mean by the term ‘currency’, how currencies work, how they affect domestic and international economics, and how it can be an important factor in deciding where and when to invest.
A currency is a generally accepted method of paying for goods and services and is the basis for trade both within a single economy and internationally.
Typically, each country has its own currency such as the British pound, US dollar, or Japanese yen. However, the euro is the standard currency for most countries within the Eurozone. The governments of both El Salvador and Ecuador allow the use of the US dollar as legal tender.
We generally think of currency in terms of ‘money’; coins and paper notes issued by the government. But increasingly we are using electronic forms of exchange – debit cards, credit cards and other electronic payment services – and these exist as balances on bank computer systems.
This is not to be confused with the new ‘cryptocurrencies’ like Bitcoin™ and Ether™ which are also held on digital ledgers but are not backed by governments.
A core characteristic of most modern currencies is that the material from which they are made – paper and base metals – has less worth than the value engraved on the face. And electronic forms of currency have no intrinsic value at all: the currency's sole value lies in its acceptance as a medium of exchange.
But if a currency has no intrinsic value, why is currency so important, why do currency values move so frequently, and why do people actively trade them?
Under most circumstances there is a finite amount of currency circulating within the economy, either the domestic or the international economy. This is controlled by the authorities, usually through the auspices of a central bank such as the Bank of England, The US Federal Reserve, or the European Central Bank.
This sets them apart from cryptocurrencies where control is entirely decentralised.
When we borrow money from the bank or have debts on a credit card, that money isn’t ‘new’ money: your bank can only lend money that it has received from elsewhere. This can be a deposit from another customer, or it can be money the bank has borrowed from another bank or from the central bank.
This makes sovereign currencies a closed system. It is the finite nature of a currency that makes it subject to the laws of supply and demand, and this is what triggers its rise and fall relative to its peers.
The marketplace for currencies is one of the few markets that is open 24 hours a day. The Bank of International Settlements estimates that the market undertakes around $5 trillion of trades every day, making it the largest market in the world.
The currency market was established to help businesses exchange one currency for another to aid transactions across foreign borders. Today, the day-to-day needs of businesses account for about 20%1 of the value of currency trades.
The remaining 80% of trades are speculative in nature, made by large financial institutions and individuals attempting to make money by predicting the future direction of a currency’s value much as they do for company shares.
Most developed world currencies are fully convertible and can be bought or sold without restriction. This is important in international trade as it allows companies to carry out their business across borders with ease. These currencies are known as ‘floating’ currencies as their relative values are allowed to float freely according to the demands of the market.
Developing countries or those with more authoritative governments often place restrictions on their currencies: there may be limits on the amount that can be exchanged at any one time, and there may be total bans on taking the currency out of the country, or special approval may be required.
Many of these are ‘fixed’ or ‘pegged’ currencies because their governments tie the currency’s value to that of another currency or a basket of currencies, or to the value of a commodity such as gold (see The gold standard: a fixed exchange rate mechanism, below).
A country generally ‘pegs’ its currency to maintain a favourable exchange rate, and make its exports competitive. However, it can be expensive as the country has to constantly buy and sell its own currency to maintain that exchange rate. This requires a large holding of foreign currency (called ‘reserves’).
Thailand used to peg the baht to the US dollar (see below), while China maintained a US dollar peg between 1995 and 2005, and again between 2008 and 2010 to protect its economy during the early years of the financial crisis.
1 Schlossberg, Eric: ‘Top 7 questions on currency trading answered’, May 2017
China currently allows its currency to fluctuate within a 2% range of the previous day’s value.
EXPLAINED : The gold standard : a fixed exchange rate mechanism
A gold standard is a system in which paper money is freely convertible into a fixed amount of gold, and it is this gold that supports or guarantees the value of money.
The most famous and most influential version of this rose to prominence in the mid nineteenth century when a number of major trading countries – Germany, France, the UK and the US – adopted it to facilitate trade.
In this system, each country sets a fixed price for gold and buys and sells gold at that price. For example, if the UK sets the price of gold at £300 an ounce, the value of the pound would be 1/300th of an ounce of gold.
Traders exchange their domestic currency to gold, which could be used to trade internationally and which could then be exchanged locally.
The system fell dormant during the First World War but was re-established under the Bretton Woods Agreement as World War II was coming to an end.
Bretton Woods saw the international price of gold fixed at $35 an ounce, effectively fixing all other currencies to the dollar.
This system remained in place until 1971 by which time the US government had more debts than it had gold.
When international governments threatened to insist on payment in gold, President Nixon formally severed the direct convertibility of dollars into gold and the modern floating currency era was born.
Currency fluctuations are a natural outcome of floating exchange rates, and are influenced by many factors. These include the relative supply and demand of a currency, economic performance, the relative outlooks for inflation, current and expected differences in interest rates, and the flow of investment capital.
It is the constant change in these factors that make currency values fluctuate almost from one moment to the next.
And as with other investments, positive economic news – low unemployment, economic growth, low government borrowing – is generally positive for a currency while bad news is generally negative.
But this interplay is not always one way: a currency can fluctuate for reasons other than economic principles, and a huge movement in the value of a currency can have major implications for an economy’s fortunes.
For most people and businesses, changes in exchange rates have ‘hidden’ impacts: in their day-to-day life most of their economic activity is played out in their domestic market in their local currency. Most of us only pay attention to exchange rates when it comes to organising that foreign holiday, although the rise of internet shopping has brought more of us into direct contact with overseas suppliers.
For this reason, many believe it important to have a strong currency as it allows us to buy goods and services (and holiday money) at a beneficial exchange rate. Indeed, the fall in the value of sterling since the UK voted to leave the European Union is often cited as a major factor in increasing food prices, as most of our produce is imported and a weak currency makes imports expensive.
The reality is a really strong currency is bad over the longer term because it makes exports expensive for international buyers. This can make entire industries uncompetitive with the result that companies close down and jobs – potentially thousands of jobs – are lost.
By contrast, a weak currency can make life expensive for individuals, but can provide wider benefits to the economy. Those same exporters now gain a boost as their prices are more attractive to international buyers. Companies with overseas operations also gain a boost as their foreign earnings are amplified when converted back to their domestic currency.
If imports are expensive and exports are cheap, the trade balance (the difference between the two) is broadly positive as it stimulates demand for exports while reducing demand for imports. The overall effect is to decrease the trade deficit or increase the trade surplus over time.
The trade balance is an important factor in determining economic growth so this is good news for economic prospects which attracts overseas investors; not just those looking to buy company shares but more importantly, those looking to establish their own international operations. By attracting foreign companies an economy boosts its employment opportunities, and this can have further long-term benefits.
But it is not all good news for corporates: manufacturers who import raw materials will face higher costs which they will try to recover by increasing prices. If the manufacturer is an exporter, this can make their products more expensive, and it can also lead to higher prices, and thus inflation, in the domestic economy.
As we have seen, a weak currency can result in ‘imported’ inflation as the increased price of essentials makes it more expensive to buy them. When it comes to tackling inflation, one of the tools central banks can use to control spending is the interest rate. By making borrowing more expensive, the central bank hopes to restrict non-essential spending and thereby suppress demand. Lower demand leads retailers to keep prices low to attract customers, and this keeps inflation in check.
While this is not great news for borrowers, increasing interest rates is good news for savers and investors. It makes the currency more attractive to overseas investors, and this leads to an increase in its value. This is then reflected in new inflation data as imports become less expensive to buy.
This makes the relative value of the domestic currency in the foreign exchange markets an important factor when central banks set their interest rates, and there is a delicate balancing act between allowing some inflation and encouraging growth on the one hand, and controlling inflation and weak exports on the other.
Currency traders therefore spend a lot time trying to predict the intentions of central banks.
Currency moves can have a wide-ranging impact not just on a domestic economy, but on the global one, too. There have been times when currencies have moved in a dramatic fashion, the reverberations of which were felt around the world.
For example, the Thai baht had historically been pegged (fixed) to the US dollar but came under intense attack from currency speculators. This forced Thailand’s central bank to abandon the peg and float the currency in July 1997.
As a consequence, the value of the baht plummeted. This triggered a financial collapse that spread rapidly to the neighbouring economies of Indonesia, Malaysia, South Korea and Hong Kong. Bankruptcies soared and stock markets plunged. More recently, concerns that the deeply indebted nations of Greece, Portugal, Spain and Italy would be forced out of the European Union, causing it to disintegrate, led the euro to plunge 20% in seven months, between December 2009 and June 2010. Although it recovered over the following twelve months, a resurgence of EU break-up fears led to a 19% slump in the euro between May 2011 and July 2012.
Currencies play a much greater role in our lives than most of us realise, with a balanced interplay between the currency markets, interest rates, and economic conditions.
Directly or indirectly, currency levels affect a number of key economic variables. A weaker currency can increase the prices of imported groceries in your local supermarket; it can also make exporting locally grown or manufactured foods more attractive than selling them locally. This reduces domestic supply which can also increase prices in shops.
They can play a role in the interest rate you pay on your mortgage or bank loans. If a weak currency results in rising prices, a central bank might increase interest rates to reduce demand.
They affect the costs of manufacturers that import raw materials or components. For companies that export goods or services, or which have overseas operations, it can boost or reduce their earnings.
And of course, increased interest rates affect the ability for companies to meet debt repayments.
These in turn can influence the returns on your investment portfolio. Not only in relation to investments in domestic shares and bonds, but also in the returns achieved if you invest overseas. It might make a company more attractive to a foreign takeover, usually at a higher price than the one the shares currently trade at, and this can also be positive for returns if your asset manager invests in the target firm.
Finally, sustained periods of weak or strong currency can influence whether companies close down their operations or open new operations which can affect employment levels.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at October 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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