Currency denominating issues: perspectives and possible solutions

1
Currency denominating issues perspectives and
possible solutions

• Xu Mingqi
• Shanghai Academy of Social Sciences

2

• What is the currency denominating issue?
• Denominating trade vs denominating financial
  transaction
• World currency function of the US dollar and the
  Euro
• Will there be an Asian currency?
• Determinants in choosing currencies for
  denominating bonds
• Asian bond market denominating issue

3
What is the currency denominating issue?

• Basic functions of money
• Measurement of value (unit of account)
• Medium of exchange (transaction)
• Means of store of value
• Means of payment

4

• Measurement of value is the base and most
  important function of other functions of money.
  To measuring the value by currency is called
  denomination.
• Longman dictionary definition a standard of
  quantity, size, measurement, or esp. of value.
• According to dictionary, its basic meaning is to
  give name to something. In economic term, it is
  to give a standard of value.

5
Denominating trade vs denominating financial
transaction

• Money and then currency was first used in real
  economic transactions as measurement of value and
  mediation of transactions.
• Later on, other means of credit sometime replaced
  money as means of mediation. And transactions of
  these means of credit emerged. As financial
  transactions increases, money or currency
  denominating financial transactions also become
  more important in the sense of measuring values.

6
Historical perspective of denominating issues

• Under the gold standard system the name of money
  is different but the essence of money and the
  ultimate standard of measurement of value is
  gold. Goods and services could be denominated in
  Pounds sterling or the US dollar, however, real
  standard is the weight of pure gold measuring the
  real value.

7

• Under modern paper currency system, money value
  itself is changing and dependent on issuers
  credit. So different currency denominations will
  have different effect. Choosing different
  denominations have become meaningful in measuring
  real value and the maintaining stability of the
  value.

8
World currency function of the US dollar and the
Euro

• Within a country or a independent economic
  community that has its own currency, economic
  transactions are mostly denominated in its own
  domestic currency.
• In some cases, money substitution occurs and
  other currencies could be used in domestic market
  either in denominating transactions or even as
  mediation of transactions. Dollarization is often
  seen as typical phenomenon of money substitution.

9

• However, in most cases denomination of domestic
  transactions is not a problem.
• In international transactions, choice of currency
  denomination become an issue for many reasons
• The space for transaction expands outside a
  currency boundary (should be acceptable at least
  by both sides).
• Additional risk in currency value (exchange rate,
  interest rate, fees involved).
• Convertible in all conditions
• Convenience of managing the payment.

10

• After the gold-standard system, pound sterling
  and other currency had once played key
  international currency role.
• However, after World War II, the US dollar was
  used most widely as denominating currency and
  medium of exchange in international transactions.
• Even after Bretton Woods system collapsed, the US
  dollar still has been the most important currency
  in denominating international transactions in
  spite of that some other currencies were also
  emerged as international reserve currencies.

11

• After 1999, the Euro emerged as second most
  important international currency when the EU
  entered into Economic and Monetary Union.
• Since then, increasing international transactions
  have been denominated by the Euro, especially
  some financial transactions, such as
  international bonds, have been denominated more
  by the Euro.
• While international trade may probably still
  denominated dominantly by the US dollar (70-80),
  the international financial transactions
  gradually become dual polarized.

12
Will there be an Asian currency?

• Monetary cooperation and integrating in East Asia
  is moving ahead and many initiatives and
  proposals have been put forward.
• However, Asian monetary unit (ACU) is still under
  discussion.
• Either JPY or RMB is not suitable to be adopted
  as regional key currency for denominating
  transaction in the region.
• We should push forward East Asian monetary
  cooperation if we do not want to see bipolar in
  the international monetary system

13
Factors in choosing currencies denominating real
international transactions

• Denominating currency should be stable in in its
  value
• Full range of convertibility
• Easy transferring through international banking
  network
• Convenient for book keeping

14
Determinants of denominating international
financial transactions

• Besides similar factors for real transaction
  denomination, some other factors are also
  important for international financial transaction
  denominations.
• Usually issuer (debtor) determines the currency
• They will take risk consideration
• Also management issue (legal, administrative and
  market)
• Relative cost of different currency denomination

15
Currency choice in denominating bonds

• For issuer, two factors are most important
• Exchange rate risk management (matches cash
  inflow in the future)
• Borrowing cost (interest rate, liquidity,
  regulatory cost and hedging or swap cost etc.)
• For investor, the most important factor is high
  yielding of bonds (interest rate differentials,
  stronger exchange rate)

16

• Benjamin H. Cohen from BIS studied interest rates
  and exchange rate of 8 currencies and their share
  changes in bond denomination between 1993 and
  first quarter 2004. He found that stronger
  currency and relatively higher interest rate
  tended to be associated with more use in
  international bond denomination.
• He believed that issuers were willing to concede
  higher returns (higher cost) either because they
  do not share the beliefs of higher cost or
  because they are able to use derivatives to pass
  the cost to the counterparts who do not share the
  beliefs (of exchange rate or interest rate
  exposures).

17

• If Benjamin H. Cohen s study is meaningful, it
  suggested that currency denomination of
  international bonds actually is decided by
  investors preference.
• Because is the investors who determine whether to
  invest to a certain currency denominated bonds.
• This is also the reason that Asian Bond Fund 2 is
  created to invest in Asian local currency bond
  markets.

18

• Currency choice in international Bond and note
  market (new issuance in billions of US dillars)
• Sources BIS Quarterly Review Part 3, June
  2005 and March 2006.

19

• Compared with that of pre-Euro period issues
• (in billions of US dollar or percentage)
• Sources OECD Working Papers No. 174

20

• Issuer of bonds and notes in international market
  (in billions of US dollars)
• Sources BIS Quarterly Review Part 3, June
  2005 and March 2006.

21

• Emerging markets international issuance in local
  currencies had been declining since 1999.
• In 2005, local currency issuance started to
  recover. The whole year amounted to 6.3
  billion. However, it falters in 4th quarter of
  2005 again.
• In 2005, Latin America local currency issuance of
  international debts totaled 4.2 billion.
• Asia-pacific region only issued 1.4 billion local
  currency denominated international debts.
• Asia has more reason to catch up in boost local
  currency bonds.

22
Asian bond market denominating issue

• As stated before, people in Asia is used to
  denominating their international financial
  transactions in the US dollar. Bond issuance is
  usually denominated in the US dollar or the Euro
  recently.
• Should we increase local currency denomination in
  international financial transaction? What is the
  specific risk for local currency denomination?

23
Local currency bond benefits and risks

• Benefits
• Reducing Currency mismatches
• Boosting domestic bond market
• Promote regional monetary and financial
  cooperation
• Risks
• Lack of liquidity and second market vitality
• Exchange rate and interest rate uncertainty
• Weak legal and regulatory infrastructure

24
Efforts in promoting Asian local currency bonds

• Asian bond fund 2 is aimed to invest in local
  currency bonds and promoting local currency bond
  market.
• Asian Bond Market Initiative taken by ASEAN3
  financial ministers (6 working groups are working
  on this).

25
Will basket currency denomination a solution?

• There were 4 kinds of basket currency denominated
  bonds in history EUA, eurco, SDR and ECU
• Three of them turned out not to have much staying
  power and were short-lived.
• (ECU) European unit of account, consisted of 17
  currencies and gold. There were 96 issues
  amounting 2 billion between 1963-1982.
• (eurco) European composite unit, 9 European
  Economic community currencies.Only three private
  issues were made during 1972-1973.. Three bonds
  amounting 130 million were issued in 1972-73. It
  was succeeded by SDRs in 1975.

26

• SDR denominating bonds were issued 13 times
  amounting 594 million according to BIS
  statistics. It has not been seen for many years
• ECU is considerably successful and turned into
  Euro in 1999
• The advantage of basket bond
• Diversification and stable in value
• Regulatory arbitrage
• Disadvantage of basket bonds
• Complexity in legal terms and accounting
• Lack of liquidity

27
Asian Basket Currency Bond proposal

• Professor Takatoshi Ito in Tokyo University
  proposed Asian Currency Bond (ABC).
• His idea is good in the sense of promoting local
  bond market in East Asia.
• However, there have not been any case of a random
  basket of currency denominated bonds in history.
• Complexity in legal terms and accounting and
  lack of liquidity could make the idea impractical.

28
Could ACU be a possible solution?

• Theoretically ACU could be a choice.
• In the short run, ACU is not going to be a
  candidate of a virtual money for East Asia.
• Special efforts has to be made in determining the
  composite of currencies.
• If there is no any cooperation fund linked to
  ACU, it is very difficult for the market to
  accept it.
• So the real solution lies in speeding up regional
  monetary cooperation.