What Is An International Currency?

International currencies play a crucial role in the global economy, serving as a medium for cross-border trade, investments, and tourism. Understanding these currencies is essential, as their values fluctuate based on a variety of factors, including economic strength, geopolitical events, and market speculation.

A global currency extends its reach beyond the confines of its issuing nation, serving not only as a medium for transactions with the residents of the said nation, but also functioning as a facilitator of exchanges between individuals who are not residents of that country.

Put simply, an international currency is a currency used instead of the national currencies of the parties directly involved in an international transaction. This transaction typically involves the purchase of goods, services, or financial assets. The use of an international currency streamlines and simplifies these transactions, facilitating smoother global trade and economic interactions.

The use of an international currency facilitates substantial cross-regional trade through invoicing in that currency. Moreover, the currency must exhibit a high level of exchange rate stability, influenced by market forces, and possess a deep and liquid market. It should also offer a wide range of accessible hedging products to both residents and non-residents.

What Are The Important Determinants That Support Currency Internationalisation?

There are several key determinants that support currency internationalisation.

Eeconomic size: The larger and more stable an economy, the more likely its currency is to be used internationally.
Financial Market Development. A well-developed, open, and liquid financial market attracts foreign investors, increasing the use of the currency. The facilitation of capital account convertibility and the establishment of offshore centres are essential factors that enable the internationalisation process.
Network Effects: Once a currency is widely used, it attracts more users due to its liquidity and low transaction costs.
Confidence in the value of the currency: Central bank credibility, low inflation, and sound fiscal policy all influence this.
Political Stability: political stability and the rule of law in the issuing country can enhance the attractiveness of a currency on the international stage.

The importance of the depth and liquidity of financial markets in the internationalisation process cannot be overstated. These factors are crucial as they offer both borrowers and investors access to extensive and easily convertible onshore financial markets. This accessibility is key in facilitating the necessary hedging of currency and credit risks.

As participants in international markets, these players need to manage these risks, making the depth and liquidity of financial markets an essential component in the internationalisation of currencies.

Functions Of An International Currency

An international currency has to effectively carry out critical monetary functions on a global scale. It must act as a medium of exchange, facilitating smooth and efficient international trade and cross-border transactions. It’s important that it serves as a unit of account, providing a standardised measure for pricing goods and services internationally, thereby simplifying trade and investment.

Notably, it also operates as a store of value, allowing individuals and institutions to preserve their wealth over time. These functions take place across two key arenas – private and public transactions, leading to the currency playing six distinct yet interconnected roles in the global financial system.

Process Of Internationalising A Currency

The process of internationalising a currency encompasses multiple stages that allow the currency to be used freely outside the issuer’s nation. Here is a simplified breakdown of the roadmap suggested by Kenen (2009):

Full freedom should be granted to both domestic and foreign entities to trade in the country’s currency, either in the spot or forward market, without any restrictions.
Domestic firms should be empowered to invoice their exports in their own national currency. Similarly, foreign companies should be able to invoice their exports in the same currency, even when trading with third-party countries.
The country’s currency, as well as financial assets denominated in this currency, should be available for holding by foreign companies, financial institutions, official establishments, and individuals based on their needs and risk-assessment.
It’s important that not just foreign entities, but also local institutions from the issuing country, can issue instruments denominated in the local currency in overseas markets.
Finally, international financial institutions, like the World Bank and regional development banks, need to have the ability to issue debt instruments within the issuer’s market and use the domestic currency for their financial transactions.

These steps, along with factors such as economic size, global trade involvement, financial market depth, macroeconomic stability, and capital account openness, influence a currency’s international usage.

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Advantages

Currency internationalisation offers significant advantages to a nation’s economy.

It mitigates exchange rate risks for local businesses involved in global trade. As internationalisation deepens the financial market, companies gain the ability to manage their financial transactions in local currency, shifting the exchange risk to foreign entities.
It paves the way for domestic companies and financial institutions to access global financial markets without worrying about exchange rate fluctuations. An expanded and efficient financial sector can also serve the domestic economy better by reducing capital costs and inviting more financial institutions to contribute capital, thereby enhancing economic growth and reducing unemployment.
It facilitates the financing of the current account deficit through private capital inflows from overseas, particularly from the banking sector, as the domestic currency becomes more globally integrated. This diminishes the reliance on substantial foreign exchange reserves to address external vulnerabilities, thereby eliminating the related expenses.
On a macroeconomic scale, the internationalisation of currency plays a crucial role in mitigating the repercussions of abrupt halts and reversals in capital flows. It enhances a nation’s capacity to repay external sovereign debts, thereby fostering economic stability.

The Financial Implications Of Currency Internationalisation

It’s important to note that currency internationalisation carries its inherent set of challenges, which may, initially, result in amplified fluctuations in its exchange rate.
This can lead to a clash, known as the Triffin Dilemma, between domestic monetary policies and the responsibility of a nation to fulfil international demand for its currency. Moreover, external shocks can be intensified by the internationalisation process due to the unrestricted movement of funds across countries and currencies.
Currency internationalisation could potentially increase instability in exchange and money markets, thereby adding complexity to the enactment of monetary policy.

Nevertheless, the advantages of currency internationalisation, including minimised exchange rate risk, reduced capital costs due to enhanced access to global financial markets, substantial seigniorage profits, and lessened need for foreign exchange reserves, usually surpass these challenges.

Understanding Different Currency Categories

There are three primary types of currencies that serve different purposes in the financial world: reserve currencies, payment currencies, and accounting currencies.

A reserve currency, essentially, is a form of ‘safe-keeping’ wealth. It is primarily utilized by public institutions, primarily central banks, to maintain their wealth in a readily accessible form.
A payment currency is the specified currency used in a transaction involving two entities. The selection of this currency is an agreement made between both parties during the establishment of the transaction contract.
An accounting currency is used to record transactions between two parties. The choice of the accounting currency can be converted as per the needs of the involved entities, providing flexibility in financial reporting.

How Payment System Is Different From A Currency

A payment system and an individual payment currency aren’t the same thing. To clarify: a payment system can either be national or global in scope. When we talk about a national payment system, we refer to a system where payment instructions are swapped in a secure, encrypted format, and settled on a Real-Time Gross Settlement (RTGS) basis or via ‘net’ settlement. This is exemplified by a cheque clearing house, which operates on a net settlement basis.

When it comes to a global payments system, the London Clearing House stands as a primary example, while SWIFT acts as a model for a payments messaging system.

However, neither of these systems is synonymous with an individual payment currency, which is a separate concept altogether.

Foreign Exchange Market

A foreign exchange market is where currencies are traded against each other and the value or exchange rate of the currency is determined in these markets.

In a freely floating exchange rate system, currencies that are freely convertible trade actively in foreign exchange markets so that there is sufficient trading to determine the values of those currencies. The number of participants and volumes of transactions determine the depth and liquidity of these markets.

The World Of Currency Trading

Currency trading takes place in a specialised market known as the foreign exchange market, where different currencies are exchanged and their values are established against one another.

In a scenario where the exchange rate floats freely, it’s in these markets that easily convertible currencies are traded extensively. This allows the market to determine the values of those currencies based on the trading volume. The depth and liquidity of these markets are influenced by the number of participants and the scope of the transactions made.

Currency traders, also known as foreign exchange dealers, help facilitate the currency trading process by connecting buyers and sellers from around the world. Their expertise in international finance allows them to offer advice and services on exchange rates, hedging strategies, and more.

History Of Currency Internationalisation

The history of currency internationalisation dates back to the Bretton Woods Agreement in 1944, a system that established the U.S. dollar as the world’s reserve currency. This agreement led to the creation of the International Monetary Fund (IMF) and the World Bank. Under this system, currencies were pegged to the U.S. dollar, which was itself convertible to gold.

The Bretton Woods system collapsed in 1971 when the U.S. abandoned the gold standard, leading to the establishment of floating exchange rates. This period saw an evolution in the internationalisation of currencies, with the euro emerging as an alternative to the U.S. dollar.

In the early 1980s, Australia embarked on a process that eventually led to the internationalisation of the Australian dollar. This process was fraught with challenges, but by 1983, the Australian dollar had become a floating currency and was gaining traction internationally.

China, spurred by the Global Financial Crisis, started an ambitious project to internationalise its currency, the renminbi. Over several years, these efforts culminated in the yuan becoming the fifth-most traded currency in 2022.

In Asia, the yen, Australian dollar, and the renminbi have become widely used in international transactions. Despite Singapore’s status as a major financial hub, it has not deliberately sought to internationalise its currency. The internationalisation of currencies continues to evolve, driven by economic, political, and technological changes.

Do You Know?: In the 19th century, Britain’s dominance in international trade and investment propelled the pound sterling to become the first widely recognized international currency in modern times. This achievement was a testament to the nation’s economic prowess and global influence. At one point, the Swiss Franc held significant importance as an international currency, serving primarily as a safe haven for savings rather than playing a major role in international trade or resource mobilisation.

Emergence Of Alternative Currencies And Future Outlook

The process of globalisation, along with the resulting distribution of global output and power beyond the confines of the Western world, has given rise to a more diverse and multipolar global economy.

The ongoing geopolitical events, particularly the Ukraine conflict that commenced in February 2022, alongside the freezing of a substantial portion of Russia’s foreign exchange reserves by western nations and the suspension of its banks from the SWIFT messaging system, are expected to hasten this process of diversification.

Consequently, it may result in a further evolution towards a more multipolar international monetary system.

The growing strength of alternative currencies like the Chinese yuan is likely to result in a shift towards the usage of other reserve currencies, which could further threaten the US dollar’s share in global foreign exchange reserves.

The potential of the Renminbi (RMB) as a global reserve currency is considerable. As the currency of the world’s second-largest economy, the RMB’s role in global finance has significantly expanded in recent years. China’s increasing influence in global trade further enhances the RMB’s standing.

Moreover, internationalising the RMB aligns with China’s long-term economic strategy, which includes reducing its dependence on the US Dollar.

As of March 2021, the RMB holds a share of 4.3 percent in global FX reserves, up from 1.7 percent in 2013. This trend is likely to continue in the future, given that the Chinese government has adopted several initiatives to make the currency more attractive to investors and international users alike.

Nevertheless, the process might be sluggish due to the limitations of full convertibility of the Renminbi on the capital account, coupled with the under-developed and relatively opaque nature of the Chinese financial markets compared to those in the United States.