Evolution of USD as forex

What is Foreign Exchange?

There are several accepted Global/Reserve currencies viz USD, GBP, YEN, EURO etc. A country needs currency to settle Import/exports of goods and services and grants and subsidies in various forms.  Besides countries keep Gold, SDR, Sovereign Debts, Treasury bills.  Countries keep Foreign exchange in their vault to regulate exports and imports, meet expenses, repay withdrawing investors in case of war or emergency, settle loans, Investments, and goods & services bills;

Currency Composition of Official Foreign Exchange Reserve (COFER)

The foreign currency reserves of all countries contributes around 58% of USD. Out of 11.418 Trillion USD Forex reserve, 6.617 Trillion USD are in US Denominated USD. This was 51% in Q4 of 2016. Confidence in USD by other countries have been increasing over 2 years.
[Refer Graph 1]

Why USD as an acceptable Forex

US constructed its Gold Repository vault at Denver Mint in 1935. The Gold stored at Denver Mint between Jan 1937 to June 1937 was 10947 metric tones and by March 1941 the Gold storage swelled to 19757 metric tones which was 65.58& of total US Gold reserves.

Prior to 1944 Bretton Woods agreement, most countries were on the gold standard. This also meant that all the countries were liable to settle their currency liabilities in Gold. In 1944, countries met in New Hampshire, and agreed to peg the exchange rate for their currencies to the U.S. dollar. US being having largest gold reserves that time, gave confidence to countries for backing their currencies with Dollar

IMF in 1969, created a monetary reserve currency to supplement existing money reserves of member countries created in response to the limitation of gold and dollars as mean to settle international account

Constraint in Supply of USD to meet increasing needs of the world

During 1970s, in order to combat inflation countries began demanding gold for the dollars. Rather than allow Fort Knox to be depleted of all its reserves, President Nixon in his controversial economic policies leading to stagflation, separated gold from USD pegging (already world’s top reserve currency at that time)

Concerns over US Deficit resulting in value of USD

in 2009, China and Russia raised concerns of intrinsic value of USD in case the inflation sets. US might print US Treasury to support its debts and its budget deficit.

They demanded for a new Global Currency not connected to individual nations and is relatively stable independent of characteristic change in individual currencies.

Yuan was awarded the status of reserve currency by IMF on 30th November, 2015. Yuan also found its place in Special Drawing Rights (SDRs) Basket on 1st October 2016. The other currencies forming part of SDR are Euro, Yen, GBP and USD. To be able to be able to freely trade as forex, Yuan must be free-float currency.

Is USD still a better bet

Answer is Yes, as the other countries hold 6.6 Trillion Dollars in their COFER and any devaluation in USD will lead to severe financial impacts on other countries. Therefore, it is in best interest of the other countries to keep faith in USD.

At the same time, it is important to note that the US Debt-GDP ratio has been continuously rising since 2007 and is at 108% in 2020. The similar ratio was observed in 1941 when World War ended. Since FED rates are very low, a ratio Debt-GDP ratio of 300% is considered as comfortable. This ratio at 50% can be alarming for other developing countries with higher interest rate.

Inflation or Recession in US can lead to higher interest and higher debt servicing ratio, which can raise nerves of other countries. [Refer Graph 2]

Is Gold changing hands? Are we prepared?

An estimated above the ground 190,040 Metric Tonnes Gold exists in the world and 50,000 Metric Tonnes Gold still to be mined.

The Current Gold reserves of top 10 Countries. The total Gold reserves of 20 Countries is 30,000 Metric Tonnes (~18%) of Total gold available in the world.

US Central Bank still number 1 in terms of holding Gold of ~8100 Metric Tonnes is almost halved since start of its Gold Repository in 1941. At the same time. India holds only 633 Metric Tonnes in 2019. While Germany, Italy, France, China, Russia holds sizable chunk of Gold reserves. India needs to evaluate its Gold reserve Position vis a vis its Forex reserves [refer graph 3]

Is increase in Forex a Euphoria?

India’s Foreign exchange reserves rose to all time high and are currently at 476 Billion USD. India’s COFER consists of 6.8% as Gold while rest 93.2% is in foreign currency, SDRs, and reserved position with IMF. The Gold reserve ratio is 16% for the top 20 countries. US Tops the list with 77% as Gold reserves.

US, Germany, Italy, France holds Gold reserves more than 50% of their total exchange reserves. However, China holds 3% and India holds 7% This is a contrast for developed and developing countries. [refer graph 4]

Similarly, Net FDI Inflow of 529 Billion USD since 1998 till 2019 are valuing at 37 Lakh Crores as against their value of investment of 30 Lakh Crores Rupees. MTM liability of reduction by 25% due to dollar valuation. — Saving However, Gold value would have been more than doubled.

The accretion to foreign currency to our foreign exchange reserves since 1998 is 413 Billion USD, however, had this addition to foreign currency been invested at prevailing rate in respective years, the Forex reserves would have valued at 959 Billion USD. [refer table 1].

Of course, market equilibrium of increased demand and limited supply of Gold would try to set in. But then we should also remember that G7 countries hold big Gold reserves.

Bottom line

We have demonstrated that accretion of Gold inplace of USD would have doubled in terms of its current value. Whereas holding USD since 1998 gave us a saving of 25% due to MTM valuation of Dollar. Its time that we carefully evaluate our COFER in order to avoid any unforeseen USD valuation risk for our hard earned Foreign Exchange reserves.


References:

https://www.thebalance.com/world-currency-33059312

https://www.investopedia.com/terms/s/sdr.asp

GET https://api.exchangeratesapi.io/latest HTTP/1.1

India is 3rd in terms of GDP at PPP

Nominal GDP is the aggregation of all Gross Value additions in one year in any country at prevailing prices. It sums up all Business outputs, Business Investments, Government spending and Net Imports

Nominal GDP of top 10 Countries

“World Economic Outlook Database, October 2019”IMF.org

But wait before we jump into conclusion let us try to understand how the denominator USD itself gets calculated

We all know value of one Rupee today is more than one Rupee tomorrow. This universal truth is valid for all the ‘financial assets’ in the world (including Fixed Deposits, Shares, PPFs, etc.). If we deflate value of a Dollar in 1960 with the yearly inflation that US underwent till 2019, the residual value of a dollar is 11.6 cents. Similarly a Rupee in 1960 has a purchase value of 1.4 Paisa due to inflation in India. We saw that Indian currency lost its value on time horizon faster than USD due to relatively higher inflation rate viz a viz US economy’s inflation. Indian Rupee lost its value 8.26 faster than USD. When we multiply this inflation parity factor of 8.26 with exchange rate of 4.76 INR/USD as on 1960, we get value of 39.33. This is the value of Dollar had all the valuations being driven by inflations/deflations.

Dollar value versus INR (split between inflation and other factors)

But that is not the case as Dollar rate on 2019 was 71 INR/USD. There is a settled gap of 32 Rupees as on 2019. This means that parity rate is not purely out of inflation of countries, there are other factors responsible for the gap in parity index such as standard of living, cost of living (inflation), resources of countries, fiscal health of the countries etc. viz a viz to each other.

The Big Mac Index is the price of the burger in various countries that are converted to one currency (such as the US dollar) and used to measure purchasing power parity. As per Big Mac Index USD should value at 33 INR in terms of purchase power of an identical burger in India vs USA. INR 33 is Not very far from our calculated value of 39 INR. As we mentioned earlier, this is due to several factors working simultaneously on the valuation of relative parity index of two countries.

Big Mac Index source :https://fxssi.com/big-mac-index
Hey we just demonstrated that the value of burger is different in different countries

The World Bank releases PPP index calculated by estimating set of prices for items chosen from a common list of precisely defined items participating countries. These common lists include both regional items, priced in the region, as well as global items, priced in all ICP regions. These sets of prices cover the whole range of final goods and services included in the GDP: household consumption expenditures, government expenditures, and gross fixed capital formation expenditures. [2]

Now that we have Nominal GDP in local currency and PPP Index, let us divide both numbers. you will find a new global power order. China tops the list with 27.31 Trillion USD followed by 21.44 Trillion USD and India at number 3 position with 5.75 Trillion USD GDP at PPP.

BJP leaders must stop saying publicly that India’s GDP sixth largest in the world. … India’s GDP third largest today

Dr Subramaniyam Swamy (Rajya Sabha MP, Fmr. Union Cabinet Minister, Harvard Ph.D in Economics ) in his tweet on 19th March 2019

References

  1. https://www.worldbank.org/en/programs/icp/brief/methodology-calculation
  2. “World Economic Outlook Database, October 2019”.
  3. http://statisticstimes.com/economy/gdp-nominal-vs-gdp-ppp.php

Interesting YouTube Video