VEHICLE CURRENCY DISPLACEMENT IN RESPECT OF HARD CURRENCIES BY

Brij Behari Dave, PhD student

E-mail: bbdave100@hotmail.com

Mobile: 09401855337

Registration No.: --735

UNDER THE SUPERVISION OF

Professor Dr. Yogesh C. Joshi

Faculty of Management,

Sardar Vallabhbhai Patel University,

Anand, Gujarat.

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Abstract

The international role of a currency is focused on the so-called vehicle currency theory. This theory is based on the observation that currencies with high volume share like the dollar are also characterized by particularly low transaction costs. It was, therefore, enough to emphasize the role of order processing costs for determining the bid-option spreads in the international markets. If there are conspicuous and visible fixed costs due to the presence of a dealer, the high volume transactions reduce the processing costs per transaction due to economies of scale. In other words, it implies that in a competitive dealership market the currencies with high volumes should have lower spreads. This inverse relationship between the volume and transaction costs has important implications for the emergence of a dominant international currency. This paper intends to address the issue of identifying the factors affecting the currency-selection in invoicing the international trade. It also empirically analyses the change in composition of the foreign exchange reserves across countries on the basis of COFER data and their relation to invoicing currency in foreign trade. The paper discusses the mechanisms of exchange-rate pass through into prices of goods as they enter a country. And in the end, it discusses about the future role of Euro and Renminbi in trade balance and in foreign assets reserves and the policy implications of the same.

Key Words: Currency, Dollar, Euro, FOREX.

1. Introduction

The international role of a currency is focused on the so-called vehicle currency theory. This theory is based on the observation that currencies with high volume share like the dollar are also characterized by particularly low transaction costs. It was, therefore, enough to emphasize the role of order processing costs for determining the bid-option spreads in the international markets. If there are conspicuous and visible fixed costs due to the presence of a dealer, the high volume transactions reduce the processing costs per transaction due to economies of scale. In other words, it implies that in a competitive dealership market the currencies with high volumes should have lower spreads. This inverse relationship between the volume and transaction costs has important implications for the emergence of a dominant international currency. For example, a transaction from Euro into the Japanese Yen could either take place directly in the euro/yen currency pair or through two consecutive transactions via the dollar as a so-called vehicle currency. In the latter case the euro balances are exchanged against the dollar followed by the exchange of dollars with the yen. This two-step procedure is more advantageous if the transaction costs of the latter two transactions through dollar as intermediary currency is lesser than the transaction cost of the single step euro/yen transaction.

The choice of the currency for trade invoicing depends on a number of factors especially after the world’s most of the currencies adopted freely floating status. This not only leads to the price uncertainty that is caused due to change in the exchange rate, but also it leads to

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uncertainties of demand, if the destination country has other cheaper sources of supply. One of the main findings of the earlier literature on the subject is that the traders seek to avoid currency risk by using their own currency. If the prices of the goods exported are fixed before the exchange rate fluctuations come to the knowledge, and orders are placed after the foreign exchange rate shock has taken place, then the exporter faces the so called ‘demand uncertainty’ if the exporter invoices the transaction in his own currency (setting the export price at the foreign currency equivalent of the domestic sales price (PCP)). If the exporter, on the other hand, prices the goods in local currency (LCP), as the exporter does not know which price he will receive (in his own currency), ‘price uncertainty’ arises. The data on trade invoicing are very difficult to get and are very scarce. However, it also depends on many microeconomic considerations at the firm level. If the demand for the exported goods is not sensitive to the price in the country importing it, the exporting firm can invoice the concerned good in its home currency i.e. PCP. However, if the demand of the exported goods is sensitive to the prices in the importing country, the firm exporting it will have to take into consideration the impact on the prices of the goods on pass-through of the effects of the exchange rate fluctuations. The demand in the importing country is also governed by many factors including the macroeconomic policies of the country, barriers to trade in terms of tariff-related barriers or non-tariff barriers etc. Exchange rate pass through can also be avoided by invoicing the trade in a vehicle currency, which is a third currency traded by both the countries. Unless the traded-product is highly differentiated, the invoicing for most of the homogenous goods is done in vehicle currency. Therefore, lots of pre-requisites are there for achieving the trade balance adjustments. It may also be possible that the importing country has such distributing companies which absorb the price rise because of exchange rate volatility and the effect is prevented from getting passed on to the consumer. On the other hand, if the exchange rate pass through is complete, the effect can be both ways i.e. the imported goods can be cheaper or costlier. In the former case it will replace local production of the good to some extent and generate greater demand for the imported good. However, if they become more expensive as compared to the local produce, the quantity of import may come down. Either way, the balance of trade is disturbed.

The theory and evidence do go to suggest that the exchange-rate pass-through into the US imports is very less as compared to imports in other countries of the world because dollar is a major international vehicle currency and a unit of accounting. As a consequence, the effect of depreciation of dollar with respect to other currencies will have significantly lesser impact on the US demand for imports while it will potentially lead to large increases in the world’s demand for the US exports which will become cheaper in the terms of the foreign currencies. The present trade imbalance in the US can perhaps follow a path of dollar depreciation. However, the role of Euro cannot be ignored. It would, therefore, be interesting to note the effect on Euro since it came into being in terms of trade invoicing as well as a share of the foreign currency assets of various countries. However, data on trade invoicing in terms of currencies and foreign reserves

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are scarce. The choice of vehicle currency depends on many criteria which are summarized below1:--

1. If there is an option to use a third country’s currency for invoicing and LCP is not selected, whichever of the home currency might be involved and the third country’s currency that has the smaller exchange rate variation with the trading partner’s currency will be selected as the invoicing currency.

2. The greater the degree of product differentiation, it is the more likely that the firm would select the PCP.

3. The higher the home country’s share in the trading partner’s market, it is more likely that the firm would select PCP.

4. The larger the size of the economy, it will be more likely that PCP will be chosen.5. When variance in the home-country money supply is smaller (larger) than in the

foreign country, the home-country firm chooses PCP (LCP).A hard currency, safe-haven currency or vehicle currency is the one that is expected to

serve as a reliable and stable store of value and unit of exchange. The factors that contribute to a currency's hard status might include the long-term stability of its purchasing power, the associated country's political and fiscal conditions and its outlook, and the policy posture of the issuing central bank s concerned .

Conversely, a soft currency indicates a currency which is expected to fluctuate erratically or depreciate against other currencies. Such softness is typically and generally the result of the political conditions and the associated country’s fiscal instability. Historically, various currencies have behaved as hard currencies like dollar, pound, sterling, guild, Japanese Yen etc. at various times. At various times many currencies have behaved as weak currencies depending on their purchasing power and fluctuations with respect to other currencies.

The following table describes the role of a currency in international purview in general. It has three important functions as follows: --

Table-1 Roles of an international currency2

Function Use by Governments

Use by Private Agents

Desirable pre-requisites of/in a country issuing reserve currency

Store of value (allows

International reserves

Foreign currencies become substitutes

Low and stable inflation; relatively strong and stable

1 Hiroyuki Oi, Akira Otani, and Toyoichiro Shirota (MONETARY AND ECONOMIC STUDIES/MARCH 2004): The Choice of Invoice Currency in International Trade: Implications for the Internationalization of the Yen

2 Sources: Adapted from Kenen (1983) and Ferguson (2008).

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Function Use by Governments

Use by Private Agents

Desirable pre-requisites of/in a country issuing reserve currency

transactions to be conducted over long periods and geographical distances)

for domestic currencies because the latter is prone to inflation and volatility. In extreme cases the foreign currency becomes the legal tender.

currency; financial markets are deep, liquid and open to foreigners.

Medium of Exchange

Vehicle for foreign exchange intervention.

Means of payment. Invoicing trade and financial transactions.

Large global share of output, trade, and finance; financial markets that are deep, liquid, and open to foreigners

Unit of Account Anchor for pegging local currency.

Invoicing trade and financial transactions.

Large global share of output, trade and finance.

Most of the research focusses on either of the three roles of a hard international currency and determines the factors influencing them. Then depending on the criteria met by various currencies, arrive at a conclusion as to which currency is likely to survive and which currency has the potential to replace the leading currency and to what extent. In this research I intend to weigh the major hard currencies of the world on all these parametric functions and then try to relate the results with each other so as to know whether the results based on foreign assets of various central banks are in consonance with the results obtained by survey of the international commodity and service trade and foreign exchange turn over in respect of major hard currencies. With the advent of Euro as a currency in 1999 and efforts to internationalize renminbi it has become imperative to assess these currencies in the above mentioned roles based on the factors responsible for the same and to arrive at the factual position as to what extent the presently prevailing key currency dollar is actually threatened by other currencies for number one position. Based on the results, this paper will also attempt to assess the effectiveness of foreign exchange interventions by various economies in the particular national interests. These results will also have impact on assessing the adequacy of the extent of portfolio management of its FOREX reserves. Euro and Renminbi are important hard currencies in addition to Japanese Yen which showed considerable improvement in the international market since recently, though on the Euro the authors across the World have concentrated on the effect of emergence of Euro on the status of the Dollar. Hence the study of evolution needs to be studied with the history of formation of European Union for a unified monitory policy across the European nations. Many authors have

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forecast that Euro will replace Dollar in the near future, including as early as 2020 and then in different years under various scenarios i.e. if the U.K. joins the EMU soon and whether USD depreciates at the same rate against Euro for almost 20 years.

2. Circulation and Role of hard currencies as Foreign Exchange Reserves

Attention of researchers has been engaged by the question of adoption of a currency as an international key currency. A currency to be a major currency in the international arena is decided by the use to which it is put. Generally speaking, an international currency plays three major roles i.e. store of value, medium of exchange and unit of account. All these functions mean differently for the official players and private/individual participants. The data relating to the official reserves suggest that while official reserves are gradually being diversified, the currency composition has not changed as much as instrument composition. Reserve managers have steadily reallocated their portfolios towards higher yielding and riskier instruments. However, this reallocation has not changed the relative position of US dollar in reserves. The Euro’s share is higher today than it was immediately prior to the EMU but it is still well below the US dollar’s share and below even the EU’s legacy currencies.2.1 Sources of data: - While data on total foreign currency are readily available from national sources as well as from the IMF, classification of these reserves by currency and instrument is harder to get. National sources provide the most detailed data but the country coverage is relatively limited. Only about 20 central banks publish details of currency composition of the reserves. As many as about 65 central banks publish details of instrument composition, but they exclude China which itself accounts for 20% of world reserves. The other major source is the Surveys. Surveys provide aggregate data, in which no individual central bank is identified, and so the reserve managers are willing to share the information. One such survey is the Currency Composition of Official Foreign Exchange Reserves (COFER). They report classification in five major currencies—US dollars, euros, yen, pound sterling and Swiss franc—plus a residual for all other currencies. The COFER data capture <70% of the foreign currency reserves as holdings of some of the emerging economies are missing. Also, in their data there is a category called ‘unallocated reserves’ for which there is no classification currency-wise.

The IMF also conducts a survey which captures the geographic distribution of securities held as reserve assets, as a part of the Coordinated Portfolio Investment Survey(CPIS). These data capture monetary authorities’ and international organizations’ combined holdings of equity and debt securities. However, the particulars of currency in which they are denominated are missing.

Counterparty’s data on outstanding liabilities from various monetary authorities, are a close proxy for asset reserves. They usually cover all the countries but the definition of liabilities to official institutions is different from the conventional definition of reserves. One such source is United States Treasury International Capital (TIC) system. It maintains separate data for cross-border holdings of US securities by official institutions from those held by private investors. On the whole they likely underestimate US dollar securities held as reserve assets.

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Finally, the Locational International Banking (LIB) statistics compiled by BIS capture reserves placed with commercial banks in the form of deposits or loans including reverse repo. Banks report their cross-border and foreign currency liabilities to “official monetary authorities” in all the five major currencies and a residual for all other currencies. Banks in all important financial centers contribute to the LIB statistics and hence the coverage of these data is quite large. However, the data held by BIS do not include the reserves held by treasuries and government agencies. They also exclude the deposits placed with BIS itself. The BIS accepts deposits from monetary authorities and invests them in deposits, reverse repos and securities. BIS itself is an official monetary authority, which accepts deposits and reinvests in bank deposits and reverse repo. Another limitation of the LIB data is that they include cross-border deposits denominated in domestic currencies. Of course the primary limitation of the BIS LIB data is that they capture only the deposits. Deposits account for a declining proportion of total reserves.

A limitation common to both the IMF COFER and the BIS LIB data is that they refer to gross reserve assets and so they give an incomplete picture of ultimate risk exposures. The net reserves excluding the liabilities are different from gross reserves. In addition, derivative positions, which are recorded separately from the transactions to which they are linked like hedges, have important impact on exposures. The management of the currency risk associated with an international portfolio has come to be seen by institutional investors as a way to generate higher returns. Hence the management of currency risks by banks becomes a conspicuous attempt on the part of the banks and in the process the banks increase exposure of reserves to currencies other than US dollar. 2.2 Currency composition

In spite of these caveats, the IMF COFER and BIS LIB data suggest that over the past decade, there has been little diversification away from the dollar. These data indicate that the inertia effect is not so strong as emphasized in the literature. The lowest point in US dollar assets holding was in 1990 at 45%, which rose to 70% in 2001 as a result of huge accumulation of foreign exchange reserves by developing countries specially in the form of US dollars. However, its share reduced to 66% of reserves in in 2006 and to 61.2% in 2013. The exchange rate movements also contributed to some extent to the fluctuations of US dollar holdings. But this is not the only explanation for the variation. Even after controlling for exchange rates movements, the large swings in the reserve holdings suggest that reserve management decisions and diversification across currencies and countries were also important. Along with the swing in the US dollar share in assets, the share of Euro also changed from about 20% in 2001 to 25% in 2006 and to 24.4% in 2013. It has also been observed that reallocation of Euros was the most conspicuous in the countries with close trade or financial ties to the euro area, and less significant in Asia and Americas (Lim (2006)).

The euro’s share levelled off after 2003 at a level not much higher than it had in the mid -1990s. It is difficult with the help of the COFER data to compare the shares of Euros in reserves to the share of euro legacy currencies because, prior to 1998, euro area countries’ holdings of assets denominated in euro legacy currencies accounted for a large proportion of euro-denominated reserves and these reserves were excluded from global reserves after monetary

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union. These changes are shown in the Graph-1. The most significant changes of recent occurrence are relating to the changes of the holdings of Japanese Yen and sterling. The sterling displaced the Yen and became the third largest reserve currency. As on Quarter 4 of 2013, the unallocated reserves and the currency-wise reserves are represented in the following graph (Graph-I). It is seen that the unallocated reserves are considerably high in quantum and cannot be classified into currencies. As many countries do not report the holdings of its assets in various currencies by various entities like central banks, dealers, markets, FIIs, domestic individuals and foreign individuals, financial institutions etc., the unallocated reserves have kept on increasing over time. The graph-3 illustrates it below. This amount of unallocated reserves is the difference between the IFS (world table on foreign exchange) and those reported to COFER.

Graph-1

in total are represented in the form of a Pie-Chart as follows (Graph-2): -Graph-2

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 Unallocated Reserves is the difference between the total foreign exchange reserves in the IFS (world table on Foreign Exchange) and the total allocated reserves in COFER. Unallocated Reserves includes foreign exchange holdings of those countries/territories that currently report to IFS but do not report to COFER. The same is represented in Graph-3 below: -

Graph-3

The literature which is available on the factors which determine a currency to be used as the reserve currency is although fairly well established, but it often lacks in quantification in absence of reliable data. The three key factors identified are as follows: -

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1. There are a number of determining factors which are very significant in deciding about the eligibility of a currency as the vehicle currency. The most important, however, is the size of the country in terms of GDP, exchange-rate volatility etc.

2. Network externalities or economies of scale and scope are important. Each country uses the currency in its trade whatever currency is used by others. Therefore, international currency use is non-linear in terms of determinants.

3. In chronological sense the switch happens slowly. Whatever currency was used in the past the same currency will continue to be used in future for quite some time. This phenomenon is called inertia.

For the purpose of this research, as discussed above, we have data on holding of foreign exchange reserves for the years from 1995 to 2013. Out of the various indicators of international use of currency, the data that is available on the timeliest basis is the currency of denomination in cross-border financial transactions in respect of many countries but not all as many countries do not reveal the same and partly because the private sector data in many cases are not available. The Euro on introduction as a currency, soon after its introduction, came into use widely mostly to denominate the bonds. Within the European countries, there was a tremendous rise in the issue of corporate bonds denominated in Euros. It was also witnessed by rapid integration of the financial markets, government bonds markets, equity markets and banking in various countries of the European Union. Moreover, when Euro arrived, its share approximately equaled the sum of the shares of the Mark, French franc and Guilder. But the year before the formation of the EMU, it was less than one would get by adding the share of European Currency Units. This was as per the expectations because before 1999, all the twelve Central Banks held foreign exchange reserves including those of each other’s’ currencies. This disappeared on January 1, 1999. On the other hand, the Dollar’s share in various Central Banks’ FOREX reserves rose from 59% in 2005 to 61.2% in 2013 and the share of Euro increased from 19.6% in 2005 to 24.4% in 2013 as FOREX reserves. As per the triennial survey report of the year 2013 published by the Bank of International Settlements, the US Dollar still remained the major vehicle currency in all the financial and commodity markets. Not only this, the dollar-denominated trade constituted 87% of all trade in April, 2013. Euro was the second most traded currency at 33% in April, 2013 down from 39% in April, 2010. Also Chinese renminbi entered the list of the top 10 most traded currencies.2.2.1 Exchange Rate Volatility

Even if a key currency were used only as a unit of account, a necessary qualification would be that its value does not fluctuate erratically. As it is, a key currency is also used as a form in which to hold assets (firms hold working balances of the currencies in which they invoice, investors hold bonds issued internationally, and central banks hold currency reserves). Here the currency to be used as a unit of account, it must instill confidence in the holders that the value of the currency will be stable over a period of time, and particularly that it will not be inflated away in the future. This is very critical. In 1970s the monetary authorities in Japan, Germany and Switzerland, established a better track record of low inflation than did the United

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States, which helped their bid for international currency status. But in 1980s the mean and variance of the inflation rate in the US were both higher than the above three hard currency countries although lower than UK, France, Italy and many other countries. But the US could not maintain this comfortable position in the early years of the 21st century. Although the USA became a big debtor country, but evidence suggests that even most of the developing countries which accumulated large sums of foreign currencies in the form of nation’s foreign currency reserves (FOREX), parked their reserves in the US. This parking of the dollars back in the US in the form of Federal bonds resulted in taking care of US’s high current account deficit. In other words, on the one hand the US pays nominal interest rate on the so parked reserves, it earns high interest rates on the FDI invested in other countries. In this way, even in the event of adverse current account deficit situation and huge debt, there was considerable demand for US dollars in the rest of the world. Thus those who believed that the current account deficit and higher inflation will have an adverse impact on the position of the US dollar internationally, proved to be wrong. Nevertheless, the data on exchange rate variation of USD with Euro from 01-01-1995 to 01-01-2014 suggest that there was considerable appreciation of dollar vis-à-vis Euro during 2001 to 2003. At that time, it appeared that these situations were going against dollar as a reserve currency, but it recovered fast. The data of exchange rate of USD/EUR from 1995 to 2014 are represented below in the form of graphs-graph-4 and graph-5.

Graph-4 (1995 to 2014)3 (more fluctuation)

3 http://fxtop.com/en/historical-exchange-rates-grapg.php?

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Graph-5(1999 to 2014) (Moderate Fluctuation)

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Moreover, the statistical analysis of the varying USD/EUR exchange rate from 1995 to 2014 yields as follows: -

Table-3N Minimum Maximum Mean Std. Deviation Variance

Statistic Statistic Statistic Statistic Statistic Statistic

4 U.S. / Euro Foreign Exchange RateDEXUSEUBoard of Governors of the Federal Reserve SystemH.10 Foreign Exchange RatesNot Seasonally AdjustedMonthlyAverageU.S. Dollars to One Euro1999-01-04 to 2014-05-092014-05-12 4:06 PM CDT

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value 184 .8525 1.5759 1.221776 .1850112 .034Valid N (listwise)

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It can be seen that the standard deviation and the variance of the foreign exchange rate are quite small. However, after recovery, if the same statistics of 2003 to 2014 are worked out, it will be as follows: --

Table-4Descriptive Statistics

N Minimum Maximum Mean Std. Deviation Variance

Value 136 1.0622 1.5759 1.314970 .1034486 .011Valid N (listwise) 136

It shows that the standard deviation and variance have fallen drastically. This shows that dollar’s exchange rate vis-à-vis Euro is very resilient. The presumption, therefore, made by Chinn and Frankel (2008) that the dollar will continue to depreciate at the same rate as it did during the initial years of Euro introduction, does not hold good based on the above analysis. Moreover, the Federal Reserve never succumbs to the temptations or pressures to inflate away the US debt, the dollar continues its predominant position, although one school of thought believes that the huge US debt reflects it in negative light as the major vehicle currency of the World.

According to the Board of Governors’ US Federal Reserve’s published euro-dollar statistical series, the level of the euro started at USD 1.18 (for 1 Euro) in 1999, reached its historical minimum in October 2000 (USD 0.825) and its historical maximum in July 2008 (USD 1.599), when the US banking crisis started. This is evident from the above plot. Overall, the euro has experienced a relative appreciation versus dollar since its birth and in particular over the last 6 years.

Most of the Central Banks in the world target inflation and fiscal deficit to stabilize their economy. Therefore, a currency showing higher volatility is not very likely to emerge as a major international currency replacing the existing vehicle currency, which presently is ‘dollar’. As most of the Euro countries have pegged their currencies to Euro, the emergence of Euro as an alternative to dollar depends on its volatility. U.K. is a very important country in Europe which has not yet joined the EMU. The following figures plot last five years’ price of major currencies of the world with respect to dollar.

1. Euro: -

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2. Great Britain Pound

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3. Japanese Yen

In the above figures, exchange rates have been plotted from March 2002 to December, 2006. MACD (Moving Average Convergence and Divergence), as defined by Gerald Appel in 1960s, shows the difference between a fast and slow exponential moving average (EMA) of closing prices. The standard periods are 12 and 26 days. The formulas are as under and this measure is used by traders in the markets to ascertain the movement of the exchange rates during in their day to day trading.

MACD: (12-day EMA - 26-day EMA)

Signal Line: 9-day EMA of MACD

MACD Histogram: MACD - Signal Line

MACD = EMA (12) of price (--) EMA (26) of price (Shown in blue line). A signal line is formed by smoothing this with a further 9-day EMA. Signal = EMA (9) of MACD. The difference between the MACD and signal line is represented as histogram. Histogram = MACD (--) signal. The upper graph is the price of the currency concerned. However, it is relevant to mention here that the trend of inflation has remained by and large the similar since 2006 till 2014 and the dollar’s exchange rate has been resilient and has adjusted quickly to intermittent upheavals. There was a period of divergence as MACD moved further from its signal line (green line) and a period of convergence as MACD moved closer to its signal line (red line).

From the above figures for Euro, G. British Pounds and Japanese Yen it can be seen that in case of Euro, its price relative to dollar has mostly been bearish because since its

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inception the value of Euro with respect to Dollar has been falling and in May-June 2002 itself it crossed through zero down and continued to be below the zero line even up to December, 2006 which was against the expectations when EMU was formed. Also, the MACD line has mostly been below the signal line. As per normal trading rules, when MACD line crosses down the signal line, the currency should be sold. Up to May-June 2004, the MACD line continued to be below the signal line even while crossing zero. Only slight recovery has occurred since then and the MACD line still remaining below the Zero line (Bearish trend continues). This supports the findings on currency invoicing which has not increased significantly in Euro terms except in the Euro Zone. Therefore, behind the marginal displacement of dollar by Euro is limited to mostly the Euro- Zone countries. It is far from becoming a currency of international importance challenging the Dollar. G. British Pound has followed almost a similar trend vis-à-vis dollar during the period. Hence, it can be safely concluded that almost all European currencies have been weak as compared to dollar in the international market during this period of four years. However, Yen followed a slightly different trend. After remaining bullish up to April 2004, the currency’s MACD line crossed below zero and remained bearish vis-à-vis dollar up to September, 2006.

2.2.2 Exchange Rate Determination:

According to standard macroeconomic theory, the relative equilibrium level of two currencies is the result of short, medium and long term factors as follows:In short term, under perfect substitutability between domestic and foreign assets and excluding the risk factor, the relative value of two currencies moves in tandem with the relative interest rate differentials until the expected investment returns in both countries is the same. This is called “interest rate parity” (IRP) condition (Jacob Frenkel and Richard Levich (1981)).The IRP condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. In such a situation the investors cannot earn arbitrage profits. In medium term, the relative value of two countries’ currencies move in tandem with the current account balance positions (CAP). The country with a weaker current accounts balance position tends to have a weaker currency (Edwards,1989). The country with a current account deficit and with limited foreign currency reserves at its disposal may be forced by financial markets to depreciate its currency or alternatively, to have a sharp reduction in its domestic demand, through an internal devaluation. By contrast, the country with a current account surplus will tend to experiment with an appreciation of its currency (Krugman, (1979 and 1999)).In the long term, however, the relative value of two currencies tends to reflect their inflation differentials. That is, a bundle of goods in a country should cost the same in another country after exchange rate differentials are accounted for. This is known as Absolute or relative Purchasing Power Parity condition (PPP). The country with higher inflation rates will see its currency to lose value and the country with lower inflation rates will see its currency to appreciate.

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The Absolute Purchasing Power Parity (APPP) is derived from the basic idea of the “law of one price”, which states that the “real” price of a good, once inflation has been taken into account, must be the same across all countries. APPP maintains that the exchange rate between two currencies should be identical to the ratio of their price levels, provided that goods in each country are freely tradable and the price index in both the countries refers to the same basket of goods.

The Relative Purchasing Power Parity (RPPP), however, refers to the change in the two countries’ expected inflation rates to the change in their exchange rates as inflation reduces the real purchasing power of a currency. The higher the inflation rate the lower the RPPP of the country. The Interest Rate Parity (IRP) and the Purchasing Power Parity (PPP) are similar in the following sense of the terms: The RIP is expected to hold when there is no arbitrage opportunity in the international financial markets, while PPP is expected to hold when there are no arbitrage opportunities in the international goods and commodities markets. As financial assets adjust to new information more quickly than goods’ prices do, RIP theory works well in short run and PPP theory works well in the long run. Irving Fisher (1933) was the first economist to establish the theoretical relationship between inflation and the real interest rate. One problem with the PPP theory is that the quality of goods is hard to measure, but significant progress of this matter has been made recently (Horn,2008).

Besides these three drivers of exchange rate determination internationally, there are at least 3 other factors that investors are also concerned about. First, the quantum of the public debt as percentage of GDP of various countries matters. Countries with very large public debt relative to GDP are less attractive to foreign investors, because large public debt is paid back either through higher inflation or through financial repression which is often socially painful. In 2013, the general government consolidated debt in the euro area was 95% of GDP whereas in the US the public debt was to the tune of 104% of GDP. Second, the “terms of trade”, that is, the ratio between export prices and import prices matters as well. In a nutshell, the currency value falls when imports keep growing faster than exports and vice versa, i.e. when the current account position deteriorates. Finally, the relative economic growth of a country is also an important factor to decide whether to invest or not in a country.2.3 Relative size of the country in terms of GDP

Another determinant of the foreign currency reserves is the relative size of the countries in terms of GDP. The following figures indicate the GDP per capita from 1980 to the projected figures of 2018 of various countries as compared to the United States. Professor Wendell Cox has used 2013 IMF economic statistical data to make comparison between US, Japan, EU, China and India. The data of 2011 of China have been adjusted for PPP (Graph-6).

In absolute terms also the GDP of US alone is more than the GDP of European Union countries taken together (Data from 2006 to 2013 are depicted in the following bar charts (Graph-7 and Graph-8)). Even the size of the emerging giant i.e. China’s GDP during the same

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period is also shown in Graph-9. It can be seen very clearly that the GDP of the US has been constantly been increasing and has constantly been more than the total GDP of the EU member countries taken together. Even when the financial crisis had hit the US in 2009, the GDP was still higher than that of the European Union.

Graph-65

Graph-7

(GDP of United States, 2006 to 20140

5 Professor Wendell Cox (2013) IMF economic statistical data.

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Graph-8

(GDP of Euro Area, 2006 to 2014)

The GDP of China was also far below that of the US during this period although it can be seen that the growth registered by China in GDP was quite high on an average and on annual basis being a fast growing economy.

Graph-9

(GDP of China from 2006 to 2014)

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It is amply clear from the above discussion that the use of Dollar and Euro (to some extent) as reserve currencies of various countries of the world is pre-dominant and the USD retains its position at number one with Euro as its potential competitor. Nevertheless, the emerging role of the Chinese currency cannot be completely ignored.

As the paper reviews a number of issues related to the use of currencies in international trade, more than one decade after the introduction of the euro and shortly after steps taken by the Chinese authorities to liberalize the use of the RMB in off-shore markets, trade is an important factor in establishing a currency as an international currency, notably by fulfilling the transaction/medium of exchange and unit of account motives of currency demand. A well prepared liberalization of currency use for international trade and foreign direct investment (FDI) transactions can even be helpful in achieving the international investment and reserve currency status of a currency. While in the distant past the later was also linked to preponderance of a country in trade markets, it is now linked to the prevalence of the currency in international financial transactions, which supposes that the country in question engages at least partly in some liberalization of capital account transactions.

This paper shows theoretical and practical reasons explaining the current dominance of the US dollar and the euro in the invoicing of international trade. There is little doubt, though, that in the medium-to-long term the RMB may become a major currency of settlement in international trade. This is not only the current direction of government policy but also that of the international financial and commodity markets, as evidenced by the rapid expansion of off-shore trade payments in Chinese currency. In the meantime, however, the US dollar and the euro are enjoying a near duopoly as settlement and invoicing currencies in international trade. The stability of this duopoly is enhanced by a number of factors recently highlighted by economic analysis: coalescing, "thick externalities" and scarcity of international currencies. These attributes of the dollar and the euro are useful to explain that, until such time that RMB payments match at least the share of China in global trade, the US dollar and the euro will remain the main currencies in the invoicing and payment in the international trade both in currency as well as in the commodity markets.

A. Blinder (1996) offers a good definition after blending all the four characteristics which encompass the three classical functions of money (a medium of exchange, a unit of account, and store of value). According to him an international currency is the one which constitutes a preponderant/major share of all the official reserves of various currencies in the Central Banks; a currency that can be used "hand-to-hand" in foreign countries; a currency in which a disproportionate share of the total international trade is denominated; and a dominant currency in the various international financial markets. This paper also focuses on the currency denomination of the international trade , which although fulfills only one of the four characteristics defined by Blinder and described above, but which, for centuries, has been at the center of a country's role in the international trade and has been central to the importance of that currency internationally. When official reserves were in gold, any other metals or physical benchmark, and when international financial markets did not allow for the exchange of non-merchandise related assets and liabilities, an international

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currency was essentially a currency that was used for trade purposes - fulfilling the roles of medium of exchanges (of payment), i.e. a currency that reduces transactions costs and inefficiencies of barter trade, and of a unit of account, i.e. a currency allowing for the valuation of merchandises between two or more countries. But now that system is no more there. The unchallenged status of the US dollar as the main international currency continues since several decades (P. Kenen, 1983) and the position has been further strengthened by the expansion of various financial markets, in the context of opening up of capital account convertibility/transactions during the 80's through the year 1990's. The dominance of the US dollar in international transactions has been such during this period - as was the prevalence of the Sterling Pound in the previous century - that the academic interest on currency use had been falling somewhat, until the introduction of the euro. As the European Union has made available the data on the use of the euro, this has resulted in the increased interest shown by the analysts, specially to examine whether the advent of the euro as currency was coinciding or anyway likely to cause decline of use of the US dollar. At the same time, in the early 21st century i.e. 2000s, the progress made in the trade theory allowing for a better account of firm heterogeneity was used to improve the understanding of the micro-economic determinants of invoicing in international trade at the firm level. All in all, these factors have revived the discussion on currency use in international trade - a discussion that is now further fed by the creation of an off-shore market for the Renminbi (RMB), and the large appetite of the market for local currency financing of trade in the Chinese currency. The success of RMB use triggers new questions as to the future panorama of currency use in world trade and the event of multi-currency environment in the future.

2.4 Network Externalities and Inertia

An international currency, like domestic money, derives its value because others are using it. It is a classic example of network externalities. There is a strong inertial bias in favor of using whatever currency has been the international currency in the past. The implication is that small changes in the determinants are unlikely to produce the corresponding changes in reserve currency numbers, at least not in the short run. At the most the changes will be manifested after a long gap. In the present context, the inertial bias favors the continued central role of the dollar. Also, as already noted, economies of scale and scope suggest that, even in the long run, measures of international currency use may not be linear in determinants. There may be a tipping phenomenon when one currency surpasses the other.

Therefore, from the above discussion, it can be safely concluded that the Dollar as the key currency in international foreign exchange reserve is not likely to be displaced by even Euro till 2050 (an estimation on lines with Chinn and Frankel) as the dollar is very resilient and can withstand fair amount of shock to its value.

3. Role of currencies as Medium of Exchange/Trade and comparison with their role as Store of Value i.e. Reserves

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The BIS Triennial Central Bank Survey is the most comprehensive source of information on the size and the structure of the global foreign exchange (FX) and OTC derivatives markets. It increases market transparency and hence helps the policy makers as well as market participants to better plan their investments seeing the patterns of activity and exposures in the global financial systems. The global foreign exchange activity has been surveyed every three years since 1989, and OTC interest rate derivatives market activity since 1995. This survey is coordinated by the BIS under the auspices of the Markets Committee (for FX part) and by the committee on the Global Financial Systems (for the interest rates derivatives part). The latest survey available is of the year 2013 for the month of April.

The trading in the FX markets averaged $5.3 trillion per day in April, 2013 as compared to $4.0 trillion in 2010 and $3.3 trillion in 2007. FX swaps were the most actively traded instruments in 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion. The FX trading was mainly driven by the financial institutions other than reporting dealers. The sector-wise breakup is as follows: -

Smaller Banks 24% of the turnover Institutional Investors such as pension funds and insurance companies 11% Hedge funds 11% Non-financial customers like corporations 9%

As per the data published by BIS Triennial Survey, 2013, the USD was the dominant vehicle currency i.e. it was on side of 87% of all trades. The euro was the next currency with its share amounting to 33% in April 2013, a fall from 39% in 2010. The most noticeable feature was the emergence of the Chinese Renminbi which entered the list of the top 10 currencies in the FX markets. The data relating to currency reserve holdings of the major currencies i.e. USD, EUR, JPY, GBP, SWISS FR and OTHERS and their share of trade in the FX markets were obtained from COFER and BIS respectively and a correlation analysis of these two parameters was carried out with the following result: -

Reservepercent FXmarketturnover

Reservepercent

Pearson Correlation 1 .982**

Sig. (2-tailed) .000

Sum of Squares and Cross-products

19697.806 23856.209

Covariance 562.794 681.606

N 36 36

FXmarketturnover Pearson Correlation .982** 1

Sig. (2-tailed) .000

Sum of Squares and Cross-products

23856.209 29941.863

22

Covariance 681.606 855.482

N 36 36

**. Correlation is significant at the 0.01 level (2-tailed).

It can, therefore, be safely concluded that the correlation between the reserve holdings of a currency is significant at 0.01significance level (for all currencies for the years 1998, 2001, 2004, 2007, 2010 and 2013) when taken together.

3.1 Turnover by currencies and currency-pairs

Apart from USD and Euro, the Japanese Yen stood out as major currency registering a substantial jump in trading activity. On the other hand, the role of Euro declined over the period between 2010 and 2013. Also Chinese Renminbi saw the most significant rise in market share among major emerging currencies. The role of dollar as major vehicle currency remained unchallenged. All FX deals in with USD on one side of the transaction represented 87% of all deals initiated in April, 2013, which is 2% higher than the 2010 figure of 84.9%.

Japanese Yen, among the major currencies recorded the growth of trading in Yen by 63% since 2010. The turnover in USD/JPY pair rose by about 70% in this period. Therefore, Yen increased its share in the international FX market to 23% in 2013.

On the other hand, the international role of the Euro has shrunk since the beginning of Euro area’s sovereign debt crisis in 2010. With the increase of just 15%, trading of euro expanded less than the overall market. Although Euro remains at second position to dollar, its share in global FX market share came down from 39% to 33%, the lowest since the introduction of the common currency. The role of renminbi in global FX trading surged from $34 billion to $120 billion due to increased efforts for internationalization of the currency. It was ninth most traded currency in 2013 at global level.

This paper also focuses on the currency denomination of the international trade, which although fulfills only one of the four characteristics defined by Blinder and described above, but which, for centuries, has been at the center of a country's role in the international trade and has been central to the importance of that currency internationally. When official reserves were in gold, any other metals or physical benchmark, and when international financial markets did not allow for the exchange of non-merchandise related assets and liabilities, an international currency was essentially a currency that was used for trade purposes - fulfilling the roles of medium of exchanges (of payment), i.e. a currency that reduces transactions costs and inefficiencies of barter trade, and of a unit of account, i.e. a currency allowing for the valuation of merchandises between two or more countries. But now that system is no more there. However, in order to find out the significance of the causal relation between foreign currency reserves and the currency-wise FX trade in the international financial markets since 1998 to 2013, I regressed the values of

23

foreign exchange reserve percentage as dependent variable with the percentage share of currency-denominated forex market turnover for each currency and found the results as under: -

3.1.1 US Dollar FX Turnover

Model Summaryb,c

Model R R Square

Adjusted R Square

Std. Error of the Estimate

Change StatisticsCurrency =

USD (Selected)

Currency ~= USD

(Unselected)

R Square Change

F Change

df1 df2

Sig. F Change

1 .709a .872 .502 .378 3.07267 .502 4.036 1 4 .115a. Predictors: (Constant), FXmarketturnoverb. Unless noted otherwise, statistics are based only on cases for which Currency = USD.c. Dependent Variable: Reservepercent

ANOVAa,b

Model Sum of Squares df Mean Square F Sig.

1

Regression 38.103 1 38.103 4.036 .115c

Residual 37.765 4 9.441

Total 75.868 5

a. Dependent Variable: Reservepercentb. Selecting only cases for which Currency = USDc. Predictors: (Constant), FXmarketturnover

The adjusted R2 value is only 0.378, which means that the change in reserves of USD as a

result of the FX trade volume change is explained only up to 37.8%. However, by looking to the F-value at the given degrees of freedom from the F-table, it is found that the upper limit for F-stat is 7.71 at 0.05 acceptance level. But the F-stat we get from the figures is below this value. Hence, the correlation between reserve assets of USD is not very significantly related to the FX turnover in the financial markets. In other words, the accumulation of dollar reserves since 1998 is not very significantly related to the FX turnover of dollar in the market. There may be other factors like stability of the currency, its strong network externalities and inertia that are responsible for the same, apart from the FX trade. In fact, the reserves of dollars have come down although there is no corresponding decrease at the same pace in its FX turnover in the international markets. However, as discussed and demonstrated above, the relative share of the dollar in the reserves has come down since the advent of the Euro but as can be seen there is corresponding downwards trend in the FX market turnover. Turnover data provide a measure of market activity and can also be seen as an approximate proxy for market liquidity. In these data no distinction is made between sales and purchases, for example a purchase of $5 million against sterling and a sale of $7 million against sterling will amount to total turnover of $12 million. Direct single cross-currency transactions are counted as single transaction only. But cross-currency transactions passing through a vehicle currency have been counted separately. The

24

gross amount of each of these transactions was recorded once without offsets. This is the reason for continued high transactions in dollars in currency markets internationally despite the reduction in the reserve stock of the dollar. 3.1.2 Euro FX Turnover

Model Summaryb,c

Model

R R Square Adjusted R Square

Std. Error of the

Estimate

Change StatisticsCurrency =

EUR (Selected)

Currency ~= EUR

(Unselected)

R Square Change

F Change

df1 df2 Sig. F Change

1 .965a .984 .930 .913 3.00310 .930 53.522 1 4 .002a. Predictors: (Constant), FXmarketturnoverb. Unless noted otherwise, statistics are based only on cases for which Currency = EUR.c. Dependent Variable: Reservepercent

ANOVAa,b

Model Sum of Squares df Mean Square F Sig.

1

Regression 482.699 1 482.699 53.522 .002c

Residual 36.075 4 9.019

Total 518.773 5

a. Dependent Variable: Reservepercentb. Selecting only cases for which Currency = EURc. Predictors: (Constant), FXmarketturnover

On the other hand, in the case of Euro, the accumulation of the currency has kept pace with the FX turnover of the currency in the market. The correlation coefficient R2 is also 0.913 and the F-stat is much above the upper level of 7.71 for the given degrees of freedom. Hence in case of euro, the regression is highly significant. In other words, the nations have actually accumulated the reserves of Euro to meet the FX requirements in the financial markets. Therefore, this is also an indicator of the fact that the euro has significantly established itself in the foreign exchange reserves as well as in the financial markets. JPY FX Turnover

Model Summaryb,c

Model

R R Square

Adjusted R Square

Std. Error of the

Estimate

Change StatisticsCurrency =

JPY (Selected)

Currency ~= JPY

(Unselected)

R Square Change

F Change

df1

df2

Sig. F Chan

ge1 .651a .991 .423 .279 1.01512 .423 2.937 1 4 .162a. Predictors: (Constant), FXmarketturnoverb. Unless noted otherwise, statistics are based only on cases for which Currency = JPY.c. Dependent Variable: Reservepercent

ANOVAa,b

Model Sum of Squares df Mean Square F Sig.

25

1

Regression 3.026 1 3.026 2.937 .162c

Residual 4.122 4 1.030

Total 7.148 5

a. Dependent Variable: Reservepercent

b. Selecting only cases for which Currency = JPY

c. Predictors: (Constant), FXmarketturnover

Here also the value of R2 is just 0.279 and the F-value is much below the upper limit at the confidence level of 0.05. Hence the regression is not very significant.

Similar is the position in case of other currencies like GBP and Swiss Franc. However, in case of other currencies, the coefficient of correlation is found to be 0.652 and value of F-change (7.508) is nearing the value as per the F-table i.e. 7.71. This regression appears to be more significant than other major currencies except Euro. Hence, except Euro and Other Currencies, no other regression is found statistically significant.

The following data represent global foreign exchange market turnover (in billions of $US) by instrument and currency during April 20136.

Table-7Currency Total Spot

transactionsOutright forwards

Foreign Exchange Swaps

Currency Swaps

FX options

USD 4652 1691 588 2030 50 293EUR 1786 754 178 766 18 70JPY 1231 612 123 332 11 153GBP 631 227 69 301 5 29

A large number of instruments being transacted in USD indicates the liquidity and depth of the USD markets with low transaction costs. The large no. of swaps in USD also indicate that the currency is considered as very reliable and less akin to shocks.Moreover, trading is increasingly concentrated in the largest financial centers. For example, in 2013 sales desks in UK, US, Singapur and Japan intermediated 71% of FX trading up from 66% share in 2010. 3.2 Role of currencies in invoicing of the Trade in Goods and Services The unchallenged status of the US dollar as the main international currency continues since several decades (P. Kenen, 1983) and the position has been further strengthened by the expansion of various financial markets, in the context of opening up of capital account convertibility/transactions during the 80's and through the decade of 1990's. The dominance of the US dollar in international transactions has been such during this period - as was the prevalence of the Sterling Pound in the previous century - that the academic interest on currency

6 Triennial Central Bank Survey 2013.

26

use had been falling somewhat, until the introduction of the euro. As the European Union has made available the data on the use of the euro, this has resulted in the increased interest shown by the analysts, specially to examine whether the advent of the euro as currency was coinciding or anyway likely to cause decline of use of the US dollar.

A. Blinder (2006) defines three functions of money (a medium of exchange, a unit of account, and a store of value): an international currency accounting for a prominent share of the official reserves of central banks; a currency used “hand-to-hand” in foreign countries; a currency in which a disproportionate share of international trade is denominated; and a dominant currency in the international financial markets. Having examined other aspects, let us now focus on the use of currency in denomination of international trade.

Simultaneously, in the early years of the 21st century, the progress made in the trade theory, allowing for a better account of firm-heterogeneity and product-heterogeneity as important factors were used to improve the understanding of the micro-economic determinants of the firm level invoicing in international trade. All in all, these factors have revived the discussion on currency use in international trade - a discussion that is now further fed by the creation of an off-shore market for the Renminbi (RMB), and the large appetite of the market for local currency financing of trade in the Chinese currency. The success of RMB use triggers new questions as to the future composition of currency use in world trade and the evolution of a multi-currency environment in the future. As practically all the market turnover goes through the hands of brokers and dealers, the transaction costs can be measured by the spread between the particular currency’s bid and offer rates. The most determining factors affecting this spread is the exchange rate volatility, market volume and the order-processing costs of market-making. An efficient domestic financial system encourages capital inflows which increases the liquidity of the bilateral foreign exchange market involving that domestic currency which increases the chances of becoming a vehicle currency. Thus, on this analogy, Euro can become an international vehicle currency if the international Euro market integrates. The following data indicate the size of the domestic financial market of three most important zones in terms of currencies markets.

Table-8(In Billions of $, June 1999)7

Instruments Euroland United States of America JapanBank deposits 4918 4909 4623Bank Loans 6351 4300 4331Outstanding domesticDebt Securities

5613 14636 5238

Stock MarketCapitalization

4650 14831 6715

7 Salvator (2000)

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Total size of FinancialMarket

21532 38676 20907

It can be seen from the above data that by eliminating exchange rate risks, the EMU has been able to integrate the European Capital Market to considerable extent. The bid-ask spread has also fallen to the level of USD. But one should not be very much impressed by these figures as they do not reflect the real changes as several factors continue to segment European Capital markets. Some of the important irritants are as follows: -

A l t h o u g h the European Bonds market is large, it is not dominated by a single issuer such as the Treasury in the US. National bonds are traded separately still and have different yields. Moreover, US T-bills can be straight away used for payment at virtually no cost. There is nothing comparable to this in either the Europe or in Japan.

T h e primary dealing in government securities in Europe remains at the national level whereas the US government securities are very widely traded in the international market. Most of the countries in the world are mostly keeping their foreign reserve stock in the form of US government securities as they are the most liquid instruments available which can be traded irrespective of time and location in the world at virtually no cost.

T h e national markets in Europe also are divided in respect of tax-policies, regulatory practices etc.

E u r o l a n d still does not represent a central state like the US, neither at domestic levels nor at international level.

D e s p i t e all expectations, the European Central Bank does not act as the lender of the last resort as opposed to the US Fed and that the bank supervision is continued to be performed on the national level. This makes the European financial systems more fragile than the US.

A n o t h e r ve ry impor t an t d i f fe rence be tw ee n Euro and Dol l a r a s i n t e rn a t i o na l veh i c l e currencies is the exposure to the foreign exchange exposure. As calculated by Gross (2000), Euroland is about three times more exposed to external financial shocks as the US. The following table demonstrates this fact: -

Table-9Euroland United States Japan Germany

Exports as % ofGDP (1)

17.1 11 11.5 24.6

Exchange rate variability (2)

11.4 5.2 7.3 6.5

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Euroland United States Japan Germany

FinancialExposure=(1)*(2)

1.95 0.57 0.84 1.6

The role of US dollar remains considerably larger than the relative economic size of the US whereas the roles of other currencies remain considerably smaller than their share in the world GDP and world trade. This is because the USD intermediates in financing of trade between the EU and third countries as well as trade among third world countries.

Table-10Euroland United States Japan

Share of world GDP in%

15.5 20.8 7.4

Share of world exports in %

19.6 15 8.5

Annette Kamps in No. 665/August 2006 in the Working Papers Series of the European Central Bank has tried to empirically evaluate the effect of various factors on Euro Export Invoicing like share of export to Euro-area, share of differentiated goods, exchange rate volatility to Euro, inflation differential to Euro area, forward market and currency being pegged to Euro. All these factors were found to be affecting Euro invoicing. Also, he has evaluated the factors affecting home currency export and import invoicing which include share of exports in world exports, relative exchange rate volatility to USD, inflation rate differential to US and forward market. Among the main findings of his study is that the membership or prospective membership of a country in the EU plays a decisive role in the choice of the euro as invoicing currency in its trade. Another conclusion arrived at by him was that the introduction of the common currency in the euro are increased the invoicing in euro at the expense of dollar. The paper also finds ambiguous evidence for the importance of the exchange rate risk as a determinant of currency invoicing.However, in this paper, I have tried to find out whether the increase in the euro invoicing only has taken place at the expense of the Dollar and also tried to empirically calculate the role of the home currency in replacing dollar. From the same data used by Kamps (2006), it was found that the replacement of dollar as the vehicle currency by Euro varies in different zones in the world i.e. Euro Zone , Euro -28, Euro Cand ida tes , Res t of Wor ld and Nor th Amer ica . Under the assumption of ceteris Paribas with the available data, the results of regression for various areas were as under. The percentage of trade in USD was taken as the dependent variable during the time series 1993 to 2014, wherever data were

29

available. It is very relevant to mention that in case of some countries only one year’s data were available and in case of others data were available for many years. This skewed data is supposed to affect the result but the results do indicate towards the trend being followed.

Table-11Zone No. of countries’ Data Exports ImportsEuro R2 Co-efficient R2 Co-efficient

Euro-Zone 6 (32 years) 0.83 -1.094 0.77 -0.839

Euro-28 10(22 years)

Euro 0.99 -0.9529 0.99 -1.0142

HomeCurrency

-1.3316 -1.0337

OtherEuropeanCountries

5 (33 years)

Euro 0.96 -0.8029 0.99 -0.8719

Other countries

3 (28 years)

Euro 0.96 -1.0672 0.97 -1.1284

HomeCurrency

-0.8680 -0.8952

1. In the core Euro Zone countries, for which the data were available in respect of exports and imports currency of trade, it is found that in these countries which have adapted the Euro as the official currency, there has been a tangible effect of replacing dollar after introduction of Euro as international currency in 1999. The data from 1993 to 2014 have been considered. The substitution is almost 10% in case of exports and in imports. This shows that some of the imports are not denominated in Euro but in dollars, which are perhaps from dollar dominated countries and for homogenous manufactured goods.2. In Euro-28 countries, import displacement of dollar is more than the export displacement of dollar. Moreover, home currency displacement of dollar both in exports and imports are more than the displacement caused by Euro.3. In other European countries, the displacement of dollar by Euro is lesser in exports than in imports.4. Other countries, Australia, Indonesia, and Thailand, the replacement of dollar by Euro is more than the displacement in the Euro-Zone countries. Even the local currency invoicing in

30

exports and imports have also displaced dollar. The reason is that the currencies of these countries are also traded to considerable extent in the international trade.

Therefore, it can be seen that the phenomenon of currency displacement has been limited mostly to the Euro countries, among which also only Euro was not fully responsible for the same but the home currencies also played significant role in the phenomenon.3.4 Drivers of international trade invoicing 3.4.1 Industry characteristics: Coalescing, homogeneous goods, size, bargaining power. A new set of studies have emerged since the late-2000's to examine afresh the determinant factors for international trade invoicing. Because the aggregate data on trade invoicing are not available, researchers have used the firm-level and transaction-level data to pursue the studies, which has particularly enabled them to complement the traditional theories about the role of money in international trade transactions. In a seminal paper, Goldberg and Tille (2008) showed that exporters are much enthusiastic and take all steps to limit the fluctuations of their prices relative to those of the goods of their competitors, when the goods are substitutable (homogeneous), and hence they would opt for the invoicing currency of their competitors (the so-called "coalescing" effect). Goldberg and Tille conducted transaction-based analysis of invoicing practices by US and Canadian firms, industry-by-industry. They found that exporters in industries where the goods are close substitutes make the use of the currency of the destination country for fear of low elasticity of demand for such goods and for competitive pricing reasons. Similarly, if the exporters are from the US they do use their domestic currency for exports. On the contrary, if an exporter is from a country whose currency is having a volatile exchange rate hardly uses his own currency. This "coalescing effect", whereby exporters minimize price differences relative to their competitors by reducing the volatility and transaction costs inherent to using different currencies, "goes a long way to explaining the well-known dominance of the US dollar. The use of the US dollar in trade flows that do not involve the United States reflects trade in homogeneous products". The authors note that exchange rates regimes have considerable influence on behavior as well, for example, the exporters from the US dollar "zone" are more likely to make use of that currency. They also found that the company and transaction size are the other relevant factors which also decide the invoicing decisions. The size of the transaction is found to have an impact since the larger transactions are less likely to be denominated in the leading currency i.e. dollar, e.g. they noted that Canada's large imports are much more likely to be invoiced in Canadian dollars than in US dollars. The relationship between currency invoicing and transaction size had not been mentioned by the literature before. Country size matters as well. In general, empirical evidence tends to support the assumption that exporters, who face competition from local firms in the destination country, are likely to invoice their exports to a large market in the currency of that market. This is explained by the fact that local competitors set their prices in their own currency (even more so if these firms are price setters in international markets) - the coalescing effect reinforces this assumption. Country size may also affect invoicing in an indirect way if

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exporters are facing the strongest competition in this large export market, the weight of that market being likely to influence the whole invoicing strategy of the exporter across all markets. The bargaining power between the exporter and the importer seems to matter as well. The choice of the invoicing currency is not neutral in respect of the trader's exposure to exchange rate risk. From that point of view, the exporter and importer may be facing opposite interests: the importer might want to limit the share of foreign currency invoicing and maximize the share of its own currency, to limit the risk on its costs, particularly if it is a large customer/importer. Alternatively, the exporter would want to unilaterally determine the currency of payment that maximizes its export earnings. Golberg and Tille emphasize that bargaining power will have an impact on the currency chosen. In this relationship, size appears to be a bargaining tool for the importer, in absence of better arguments with the exporter. Finally, the concentration of retailing towards large distribution chains seems to reinforce the bargaining power of importers against exporters (Vox column by Golberg and Tille, on October 2, 2009). These results are consistent with McKinnon (1979), who found that industries producing homogeneous goods tended to trade in currencies with low transactions costs. 3.4.2 Inertia and "thick market externalities", applied to currency invoicing Consistent with the criteria developed by Blinder (1996), an international currency is one in which a disproportionate share of international trade is denominated. As shown above the US dollar is the main currency fulfilling this criterion. Its use exceeds the share of the US in international trade (on both exports and imports), and that of its trading partners within NAFTA. As the dominant currency, it is also used in third party trade, notably in the Asia-Pacific region, which has experienced the fastest growth of international trade in the past two decades. No doubt that this growth has comforted the US dollar's position globally in the invoicing and settlement of international trade. The US dollar is also widely used in the LATAM region, and in commodities markets. As indicated above, country size matters, particularly in the case of the United States; the assumption is that the currency of the exporter's country is likely to be used if the exporting country is very large relative to destination markets. This is all the truer if a country is defined from a "(trade, currency) bloc perspective" (Golberg and Tille 2008). 3.4.3 Krugman (1980) explained that inertia also plays a role in currency invoicing. He argued that the more a currency is established, the more difficult it is for users to shift to other currencies: there are clearly lower transaction costs in using a widely available and liquid currency. Economies of scales emerge as a large level of transactions in a currency ends up lowering the spreads for that currency in foreign exchange markets and in bank charges, for either cash transactions or transfers. Krugman's view is supported by the observation that, despite the end of the Bretton-Woods system and of the increased volatility of the US currency, the dollar’s established position has remained relatively unchanged in international markets. Goldberg (2012) confirms the inertia phenomenon – and the difficulty to displace well-established currencies ("everyone uses the dollar because everyone else is using the dollar"). Using a theoretical model, Rey (2001) had also looked at inertia in the use of a specific international currency. Part of this inertia is linked to the fact that if multiple currencies are being used, higher transaction costs would pass through to export prices. Hence, there is an

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incentive to use only one invoicing currency to maintain lower international prices and competitiveness. The currency of reference is chosen according to the "thick market externality" principle, whereby the transaction costs of using a particular currency in the market are reduced with market size. Therefore, the currencies of countries with large trading power, high levels of openness and substantial bilateral trade flows are more likely to be chosen. Chandrasekhar (2010) argued that the resilience of the dollar as an international reserve and transaction currency was based on overall US strength in international relations. Using alternative reserve currencies, such as IMF Special Drawing Rights (SDRs), presented problems on its own. For example, SDRs can only be used by governments and not by private entities in regular transactions. A similar example can be chosen from the process of monetary integration in Europe. While, before moving to a single currency, the European Union tried to develop the use of its internal unit of account, the ECU, its private market never took off beyond the largely symbolic labelling of limited bond issues and currency invoicing for intra-firm trade within the European Union. The composite character of the EU, the lack of reserve status currency, and the limited liquidity available, compared unfavorably with internationally-traded currencies such as the Deutsche Mark and the French Franc. 3.5 Trade, macroeconomic volatility and currency use The attractiveness of currencies is also driven by the ability of the country issuing the currency to respond to macroeconomic shocks and limit macroeconomic "volatility". Macroeconomic volatility is a function of volatility of the currency itself in exchange rates markets. Baron (1976) emphasizes the role of exchange rate volatility on both the volume of international trade and the use of trade currencies. Exchange rate volatility may have negative effects on the structure and the cost of output, profit maximization and decision to trade and not, thereby possibly reducing trade and currency use8. Some models emphasize that exchange rate risk reduces net trade, which is the difference between trade and intra-industry trade. This is evident in Kumar (1992) who argues that exchange rate risk acts as a "tax" on the comparative advantage of the exporting sector relative to the domestic sector. If comparative advantage is reduced, economies of trading countries will become less specialized and intra-industry trade will increase at the expense of inter-industry trade. More recent empirical work finds some direct, rather than indirect, impact of exchange rate volatility on currency invoicing. This is the case of Wilander (2006), who found a negative relation between exchange rate volatility of exchange rates and the invoicing strategy of Swedish exporters. Donnefeld and Huag (2003) find similar results for Canadian exporters. As explained by Corsetti and Pesenti (2005), the currency of invoicing has an influence on the way in which macroeconomic shocks are transmitted, with exporters able to price in their own currencies being less subject to exchange rates fluctuations and in a better position to pass on changes in prices linked to exchange rates changes to consumers. Importers have also a

8 (Cushman (1983), Gros (1987), De Grauwe and Verfaille (1988), Giovannini (1988), Bini-Smaghi (1991)).

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preference for invoicing in local currency to minimize their exposure to currency changes (Goldberg and Tille (2009)). Bacchetta and Van Wincoop (2005) used a general equilibrium with nominal price rigidity to show that the higher the market share of an exporting country in an industry, and the more differentiated its goods are, the more likely it is that its exporters will price the trade in the exporter's currency, notably to limit output volatility. They also found that the currency in which prices are set has significant implications for the optimal pricing strategies of firms (in particular the incentive for exporters to stabilize its price in the importer's currency), exchange rate pass-through to import prices, the level of trade and net capital flows, and the optimal monetary and exchange rate policy (to reduce transaction costs). They also consider that country size and the cyclicality of real wages play a role, albeit empirically less important. They also came to another important conclusion, whereby the currency formed in a monetary union is likely to be used more extensively in trade than the sum of the currencies it replaces. This conclusion is to a large extent evidenced by reality9. 3.6 Liquidity "Thick market externalities" are necessary but not sufficient to explain the use of large currencies to lower transaction costs. To achieve economies of scale at the international level, the market for a currency needs to be large, liquid, and global at any point in time. It should be accessible to non-residents on demand and supply currency in sufficient quantities. In the case of the US dollar, the non-resident (euro-dollar) market has been (and is) regularly supplied through the US balance of payments: US dollar balances abroad are regularly fed by the current account deficit, hence increasing abroad the volume of dollars available for trade and financial transactions. As shown by the graph below, since 1980 the US current account has been balanced only once during the recession of 1990-1991. Since this recession, the US current account deficit has actually increased for 15 years, reaching 6% of the GDP in 2006. Since the 2008-09 financial crisis, recovery of the US savings rates has allowed a reduction of the current account deficit by almost half.

9 (Cushman (1983), Gros (1987), De Grauwe and Verfaille (1988), Giovannini (1988), Bini-Smaghi (1991)).

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Graph-1210

At the same time, the US economy has been offering sufficiently strong returns on US dollar assets and monetary stability (low inflation…) to attract investment to finance the current account. Besides, current account deficits did not translate necessarily into a deterioration of US investment position. This is explained by the fact that U.S. assets overseas have gained in value relative to the domestic assets held by foreign investors. This, in itself, helped reinforce the international role of the US dollar. US net foreign assets have not been deteriorating in line with the current account deficits, except since the recent financial crisis, due to the relative under-performance of domestic ownership of foreign assets (foreign equities) in comparison to foreign ownership of domestic assets (mainly US treasuries and bonds).As a result, US dollar holdings by non-residents continue to irrigate the international financial and trading system, and constitute, for all uses, the largest pool of currency in the world. According to Goldberg (2010), for example, the very large majority of US dollar banknotes for "hand-to-hand", cash transactions, are held outside the US territory: about three-quarters of hundred-dollar notes, and half of fifty-dollar notes are held abroad. The share for all US dollar notes is 60%. US Dollar bond markets are supported by the issuance of US dollar-denominated debt, which currently account for up to 40% of bond holdings; the US dollar is also the prime currency of issuance for corporates in Asia and the Pacific, Latin America and the Middle-East, all of which have developed their capital markets in the recent years with some relation to the US dollar. According to the IMF, the largest share of international reserves is also denominated in US dollar (some 60% of the total).Another factor in favor of US dollar-denomination of trade is the large number of countries having a currency explicitly or implicitly pegged to the USD (some 90 in the world, a stable number in the past two decades) – notwithstanding full dollarization in several countries. All in all, US dollar-use is supported by a strong economy, producing little inflation, stable returns on

10 Source: IMF

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investment for non-residents, and liquid currency markets. In the international market for currencies used for settling transactions, denominating or trading assets, this mass of US dollar-denominated assets at the disposal of non-resident is of considerable advantage for maintaining the international role of the US dollar, despite some debate about whether this will continue in the future.Since Euro was introduced, two currencies hold dominating position in the world market. Although other currencies like Japanese Yen and Pound Sterling are there but they are not a substitute for dollar or euro. The data on trade invoicing in various currencies are not available. In studying the relation between the trade settled in USD, Euro or other major hard currencies on has to go to the factory-level data industry by industry in all countries. Presently, studies are available for some countries like Canada etc.

In order to estimate the relation of exports and imports of goods and services in selected non-euro countries invoiced in Euro to some European countries (i.e. Bulgaria, Czech Republic, Latvia, Lithuania, Poland, Romania and Sweden), multiple regression analysis was carried out with the percentage of Euro in total foreign exchange reserves as dependent variable and the percentages of exports and imports of goods and services as percentage of GDP as independent variable with the following results with 95% confidence level: -

Regression StatisticsMultiple R 0.918740811R Square 0.844084678Adjusted R Square 0.532254034Standard Error 1.483453202Observations 7

ANOVA df SS MS F

Regression 4 23.82730462 5.956826156 2.706869Residual 2 4.401266806 2.200633403Total 6 28.22857143

CoefficientsStandard

Error t Stat P-valueIntercept 31.85190409 36.5743188 0.870881677 0.475642ExportGood 1.211970146 0.473134874 2.561574325 0.124557ImportGood -0.021881544 0.507382308 -0.04312634 0.969519ExportSer -0.750322231 0.512953207 -1.46274986 0.281066ImportSer -0.742774076 0.695384891 -1.06814814 0.397299

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It can be seen from the observed t, p and F-values that none of the transactions in exports and imports as percentage of GDP is statistically significantly related to the accumulation of Euro in the reserve assets of various countries. Hence, it is proved that the accumulation of reserves of Euro by non-euro countries is not solely for the purpose of trade in goods and services. 3.7 Role of Renminbi in International TradeGraph 13 below shows an obvious and steep upward trend in the share of China’s cross-border trade settled in the renminbi, from almost zero in 2009 to 16.6% in the first three quarters of 2013. Of all the trade settled in renminbi, only about 56% was invoiced in the renminbi in 2012 (Li, 2013). There is empirical evidence that, in general, the currency used in invoicing is also the one used in actual payment (Friberg and Wilander, 2008). Thus, this disparity between settlement (16.6%) and invoicing (56%) is largely unique for the renminbi which shows that the Chinese government policy works in promoting renminbi settlement but the market is still hesitant to use the renminbi as an invoicing currency.

Graph-13

4. Use of Currency for intervention in International Financial Markets

Another use of currency is its role in foreign exchange intervention. Global shocks to capital flows pose a policy challenge to an economy with some openness in its capital and financial accounts. When there is surge in capital inflow a country may experience asset price inflation, credit booms and overheating of economy which results in currency appreciation and increase in financial vulnerability Various tools have been used by different countries to control the inflow like macro and micro prudential measures, regulation/deregulation of capital flows, countercyclical fiscal policy and foreign exchange market intervention. The current debate on the reforms in the International Monetary System (IMS) revolves around the topic of international reserves as more urgent than a reform of the global exchange rate system. In fact, there is very

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little criticism of the flexible foreign exchange rates system, specially its lack of multilateral rules and the strong effect it assigns to financial markets in determination of exchange rates. On the other hand, this research considers the current exchange rate system as the central problem of the IMS while the development and structure of global reserves are mainly regarded as a symptom of serious flaws that characterize the exchange rate system. Above all, the dominant role of dollar as a global reserve currency can be challenged if the countries decide more consistent exchange rate and interest rate and interest rate strategies.4.1 Myth of Flexible Exchange Rates Since the collapse of the Bretton Woods, the policy of a laissez-faire approach is being followed in the realm of exchange rates which presumes that the invisible hand of the foreign exchange markets would be able to provide the discipline and the coordination, which was hither to been imposed by IMF. The exchange rate theory for flexible exchange rates is based on the assumption that the exchange rates will eventually adjust with each other based on PPP principle. According to PPP, differences in the relative inflation rates across the countries are the main determinants of the flexible exchange rates so that real exchange rate remains constant overtime. As the differences in the rates of inflation depend on the differentials in rates of interest, the system of flexible exchange rates is at the same time based on th3 theory of Uncovered Interest Rate Parity (UIP). According to this equilibrium condition, the currency of a country with a higher nominal interest rate depreciates against a currency with a low nominal interest rates. Therefore, in this stylized world of flexible exchange rates there is no room for exchange market intervention of central banks as market-determined exchange rates provides automatic optimum adjustments to differences in national macroeconomic developments and secondly, the intervention will be made ineffective given the huge size of foreign exchange market turnover and seemingly limited amount of central bank’s foreign exchange reserves.4.2 The puzzling and disturbing reality of the flexible exchange rates The above explanation of market determined exchange rates theory based on UIP and PPP is recently refuted by many authors. They cannot adequately be explained by relationship with macroeconomic fundamentals. For very long time the debate that has been on the issue of alternative exchange regime which has been dominated by “triangle of impossibility”. According to this policy the open market economies have to make a choice from the following three scenarios:

1. An autonomous monetary policy.2. A fixed exchange rate, and3. Capital mobility.

Thus, if a country wants to avoid restrictions on capital mobility, then it will have adopt a fixed exchange rate regime and independent monetary policy or a flexible exchange rate policy and ineffective monetary policy. The theoretical basis for this approach is called Mundell-Fleming model, which shows that with free capital mobility monetary policy is inefficient under fixed rates but effective under flexible exchange rate (Mundell, 1963). Alternatively, if a country wants to have full control on the interest rates and wants to stabilize exchange rate at the same time, then it has to put in place capital controls. However, in reality, in the last decade many

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countries have been intervening heavily on foreign exchange markets, but without declaring fixed exchange rate target for their currency. This is reflected by strong accumulation of foreign reserves, especially in the emerging economies. The level of this reserve exceeds the precautionary reserve levels. The puzzle of ‘reserve accumulation’ (ECB, 2006:9) can be explained by the fact that the central banks of emerging economies have constantly intervened to maintain their undervalued exchange rate. As the current IMS does not entail any rules, the countries use this vacuum to intervene in exchange rates to support their exporters. In this paper a theoretical framework of strategy of managed floating is developed. This paper will try to explain as to how this impossible triangle can be converted into a ‘possible trinity’. This is based on the following two factors: -

1. The theoretical equilibrium condition of UIP according to which the path of equilibrium exchange rate should be identical with the difference in interest rates.

2. The number of policy instruments correspond with the number of policy targets.Mundell-Fleming model lays down that in an open economy, a central bank has to address two targets viz. external and internal equilibrium. For these two targets two instruments are needed as follows: -

1. Intervention in the domestic money market in order to control the short-term interest rate as its policy rate. This type of intervention changes monetary base.

2. Sterilized interventions in foreign markets in order to target the exchange rate. This affects the foreign exchange reserve of a country. Although this intervention also has an impact on the monetary base but its sterilization can be achieved by a compensating adjustment of domestic positions of the central bank’s balance sheets.

In an open economy these two instruments can’t be used independently. However, as per UIP, if i* is the interest rate of the foreign currency and i is the interest rate of home currency, then, the foreign exchange rate path (∆S) are possible:(i*- i) = ∆S Equation-(1)Here S is the logarithm of the nominal exchange rate expressed in quantity i.e. an increase of S will mean appreciation of the domestic currency. The internal and external policy targets will determine the optimum equilibrium of these instruments. The internal equilibrium is a situation where the loss due to output gap and inflation gap is minimized viz., the difference between the actual inflation rate and the targeted inflation rates. The Central Bank chooses interest rate which minimizes this loss. This process is also called “inflation targeting”, which is resorted to by most of the developed and developing economies. On the other hand, the target of external equilibrium in case of managed floating rates, is defined in accordance with the UIP principle, where the difference (positive or negative) between nominal interest rates of domestic and the pivot currency is coinciding with the target value for appreciation (or depreciation) of the domestic against the pivot currency. Hence the UIP equilibrium determines the target path of exchange rate. Hence, the external equilibrium consists of financial markets equilibrium. In other words, the internal equilibrium target is achieved by inflation targeting using internal short-term nominal interest rate, whereas the external equilibrium is achieved as per UIP path of exchange rate vis-à-vis the pivot currency by intervention in the forex markets. In this paper, therefore, we

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use interest rate and the exchange rate as two simultaneous operating targets so that the advantages of both can be obtained. The need to target the situation of devaluation of currency, whenever the domestic interest rate is higher than the interest rate of the pivot currency, makes it clear that the strategy of managed exchange rate can only be applied when the impact of interest rate difference is higher on the macroeconomic aggregate demand as compared to the differential exchange rates between the two currencies. In other words, floating exchange rate can’t be applied effectively where the openness of the country’s economy is less on the relative scale. In less open economy, the impact of interest rate differentials is quite high on aggregate demand. Moreover, when the problem of devaluation is to be addressed, on the domestic front the nominal interest rate is to be targeted as per the UIP theory i.e. if the difference in interest rate is ∆r, the same is targeted through the inflation target path and in the external sector, the devaluation is targeted to the equal extent, thereby giving no chance of buying foreign capital at low interest rate as the inflation rate pressure counters the same. Therefore, with the concept of managed floating exchange rate, the impossible trinity can be converted into a possibility of triangle with:

Free capital mobility Autonomous interest rate policy and An exchange rate target path which is defined by UIP.

4.3 Limitations of Managed FloatingLee (1997) observed three limitations of managed floating:

If the capital is highly mobile, the exchange rate can’t be targeted with sterilization which will prove to be futile as they are rapidly countered by renewed inflows.

If central bank targets the exchange rate with large foreign exchange intervention, there is limitation on the same as it will lose control over the domestic policy. In many cases, the policy could not be applied indefinitely because the stocks of open market bills opens so much that the domestic market can’t absorb it.

If a country targets the exchange rate with sterilized intervention, the process can be associated with high costs for the central bank. The operating losses occur when the funds it raises are invested in foreign assets, which earn interest at the prevailing rates in world’s major currencies, which are often lower than the rate of interest it has to pay on the large scale bills it has sold.

4.4 Hence the question arises: “How effective are foreign exchange market interventions”:

Most of the literature on the effectiveness concludes that the sterilized interventions are ineffective. It is fact that the central banks don’t pre-announce intervention and researchers cannot get the data easily. Moreover, it is more difficult to empirically measure the real impact on the target. From a microeconomic point of view, the situation where a central bank tries to target depreciation of the exchange rate differs from the situation in which it targets against appreciation of the currency. In the first case (of targeting depreciation of its currency), the central bank buys its currency in the foreign exchange market by selling foreign currency. As the amount of forex reserves is limited, this kind of intervention has a limited access/scope i.e. they

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are carried out under hard budget constraints. At the same time if the other traders come to know about it, they may counter all efforts of the central bank by speculating against it. Moreover, as sterilized interventions reach high volume, there is a fear of limitation of the sterilization of the increased domestic liquidity, which is associated with the purchase of foreign currency. It can do this by refinancing the credits or by issue of fresh bonds to the domestic public, absorbing liquidity or as done in India, it can be achieved by decrease in reverse repo rate or increasing CRR, which will increase the interest rates domestically affecting directly the domestic production and thereby slowing the rate of growth of economy. In principle, both the methods can be applied without quantitative limits but in extreme cases, without due care been taken, with adverse consequences on growth and output. On the other hand, if a country tries to stop appreciation of its currency, it buys the foreign currency by selling foreign currency. Here, however, the budget constraints are soft, i.e. without quantitative limit. Because of no limit, the speculators have a lesser chance to thwart the efforts of the central bank. To increase liquidity, the banking system can purchase back the bonds, central bank can increase the repo rate and reduce CRR. These measures, of adopted by India, result into maintaining the monetary base of the country.

Even without quantitative limitations for sterilized interventions in certain cases, such an operation may be associated with certain inescapable costs. The costs of sterilized costs are determined by the interest costs and the revaluation costs of the central banks of the central banks’ foreign exchange reserves. If the domestic policy rate is higher than the foreign short-term rate, the central bank loses on account of interest rate differentials from the sterilized interventions. For arriving at the total costs, the foreign assets’ revaluation costs are also relevant. If the exchange rate is targeted along UIP path and the domestic interest rate is higher than the foreign rate, then the value of the foreign exchange reserves increases which offsets a losses made due to interest rate differentials. This is also called ‘revaluation gain’. Assuming that a central bank has no foreign assets before sterilized intervention, the total costs of sterilized intervention is expressed as: -CS = (i – i*)∆FA + ∆s∆FA Equation-(2)Where FA represent foreign assets of the central bank. If UIP condition is followed,(i – i*) = -∆s,the total costs of intervention are zero. Thus we have been able to theoretical demonstrate as above that following the UIP path, the costs of foreign exchange intervention can be zero for a central bank. To sum up, taking into account the main determinants of scope and limitations of sterilized interventions, one can say that a central bank which intends to target Preventing appreciation of its currency, is in principle able to intervene and simultaneously to sterilize the liquidity effects of the interventions without quantitative limits and without operating costs. This is entirely different from a central bank that tries to avoid a depreciation of its currency. In this case it has to operate under budget constraint. Thus, the “consistency triangle” under a managed floating regime can be formulated as follows in an open economy: -

Free capital mobility,

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Autonomous interest policy and One-sided targeting of the exchange rate along a UIP path preventing an unwarranted

appreciation of the currency.However, the limited room for maneuverings where the domestic currency is in a depreciation pressure can only be overcome if two or more central banks involved are willing to cooperate. In such a cooperative environment there is always a strong central bank which can intervene without a hard budget constraint.

On the other hand, it can be seen that about 99.8% of US exports and 92.8% of US imports were in USD in 2003 (Goldberg and Tille, 2008), while 62.5% of exports and 49% of imports were invoiced in Euro in extra-Euro area goods transactions of euro area countries in 2012 (ECB, 2013). Thus the Chinese trade in renminbi is trivial in comparison with the US trade in dollars and EU countries’ trade in Euro. Renminbi will rarely be used as a vehicle currency when China is not involved, whereas in Asia Pacific region and even in Euro-zone, dollar plays the pivotal role as vehicle currency.

5. Conclusions

5.1 Current realities and prospects about currency use in trade settlements, invoicing, and other transactions (The US dollar-euro de facto duopoly State of Play)The number of international currencies having the characteristics of reserve of value and means of payment, offering stability, liquidity and substitutability, globally, are relatively scarce at the present time. The creation of the euro has certainly increased the hierarchy between the main two currencies (the dollar and the euro), and other currencies, in respect of these standards. Before the introduction of the euro, the prime currency of transaction, reserves and investment was, with no comparison, the US dollar. By order of importance, there was a second choice of currencies comprising the Deutsche Mark, the Japanese Yen, the UK Pound Sterling, the French Franc, the Australian dollar and the Swiss Franc, reflecting the importance of each currency as a trade, financial or reserve currency.While other currencies could be of importance in regional markets, they were of lesser importance in international markets.Since the introduction of the euro, two currencies are dominating the world market for currencies. Other currencies such as the Pound Sterling and the Yen are still important but are regarded as no substitutes to the US dollar and the euro by the markets. The RMB can be an alternative in the medium-to-long-term, but remains scarce by such definition – not that it is not stable or available for trade, but it still offers limited convertibility, and hence limited liquidity globally and no hedging facilities.It is interesting to note that total transactions have more than tripled in the past decade, from US dollars 1.4 trillion in 2001 to US dollar 4 trillion in 2011 reported in the Bank of International Settlement (BIS) most recent "Triennial Bank Survey".

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There are unfortunately no single set of comprehensive and consolidated statistics regarding international trade settlements and invoicing. As indicated in Goldberg and Tille (2008), data availability varies widely across countries. The authors used national studies and various additional sources of information. 5.2 Factors behind the current duopolyApplying the concepts explained above, we have seen since the introduction of the euro a relatively "stable" duopoly in currency use over the past decade - albeit there is no market barrier-to-entry preventing another large currency from be supplied and actually having success. As shown by the success of RMB use in off-shore markets, a strong demand exists for it. The main driver of RMB international development is hence for the time being of regulatory nature (for trade, mainly restrictions on good exports). However, other important factors will determine the pace of the adoption of the RMB, such as the familiarity of users, the existence of attractive trading opportunities, accessibility, and perhaps RMB appreciation expectations.This duopoly is not necessarily an imperfect competition duopoly in the meaning of the equilibriadefined by Cournot, Marshall and Nash - whereby duopolistic powers would have an interest in "cooperatively" reducing output/quantities supplied to the market to maximize profit, and hence form an effective monopoly on price setting. The currency market is still one that expands very rapidly, as evidenced by BIS statistics, and monetary authorities show no signs of squeezing supply to achieve some kind of duopolistic "Yalta" of market shares in the use of currencies. The relative "stability" of that duopoly may reflect other factors at play.The concepts highlighted above help understand the stability of the current duopoly. For example, the "thick market externalities" principle, whereby the transactions costs of using a particular currency are reduced with market size is partly linked to the absence of any other currencies in which economies of scale of that size can be achieved. The US dollar is present in 90% of all transactions in the 4 trillion dollars a day foreign exchange market. The considerable pool of liquidity in US dollars on which foreign traders can count across the world is also an advantage. The euro is present in almost 40% of all transactions. According to the BIS, the "US dollar-euro" pair (or segment) of the foreign exchange market accounts for almost one-third of total transactions, that is more than US dollars 1 trillion-a-day.Besides, thick market externalities imply that currencies of countries with a large trading power and substantial regional and bilateral trade flows are more likely to be chosen. From that point of view, US dollar and euro use is boosted by the strength of regional links (the NAFTA on the one hand, the euro-zone on the other) and the existence of large domestic markets for currency issuers. The high share of intra-trade against extra-trade is undoubtedly an advantage for currency trade-related use. In the case of the euro, invoicing in euro tend to "gain market shares" in areas that have a high proportion of goods and services trade with the euro-zone. This is corroborated by data from the European Union indicating that not only recently acceded Members of the European Union but also other Eastern European countries have increased their use of the euro in trade and financial transactions.

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As intra-Asia trade expands (its share of total Asian trade increased from 49.1% in 2000 to 52.6% in 2010), the US dollar has remained in the region at least until recently a major, if not the main, invoicing and settlement currency for international trade. According to the data published by Goldberg and Tille (2008), the US dollar share in export invoicing of Korea and Japan was as high as 84.9% and 52.4%, respectively, in the early 2000's. The share of Australia's exports denominated in US dollars was 67.9%. Thailand's export share in US dollars was exceeding 80%. Reflecting the relatively large share of row material and energy products in their imports, the share of the US dollar in Japan and Korea's imports was even higher: 70.7% and 82.2%, respectively. For Thailand, the US dollar share of imports was also over 80%, as for exports. More recent aggregated statistics have not been found. However, in a trading panorama marked by the expansion of international value-chains in Asia and the production of global goods priced in US dollars, it is likely that the use of the US dollar in Asia's trade has not greatly diminished. According to China's own statistics, RMB settlements have reached 10% of China's trade at the end of 2011, certainly one of the most meaningful developments in the region. However, China's trade accounting for about 10% of world trade, the RMB use in the world, while expanding in Asia, remains for the time being relatively small (10% of 10%). This is consistent with the BIS survey, in which the RMB accounts for only 0.5% of global foreign exchange transactions.

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7. Scheherazade S. Rehman (1998): “The Euro As A Global Trade Currency”, ISSN: 0885-3908. The International Trade Journal, Volume XII, No. 1, Spring 1998.

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13. Marc Auboin (2012),: “Use of Currencies in International Trade: Any Changes in the Picture”, WTO, Economic Research and Statistics Division.

14. Bank of International Settlements: “Triennial Central Bank Survey: OTC Interest Rate Derivatives Turnover in April, 2013: Preliminary Global Results” downloaded from BIS website (www.bis.org) on 02-03-2015.

15. Linda S. Goldberg (2010): “Is the International Role of the Dollar Changing?”, volume 16, Number 1 of Federal Reserve Bank of New York Current issues, downloaded from www.newyorkfed.org/research/current_issues on 03-03-2015.

16. Robert J. Carbaugh and David W. Hedrick (2009),: “Will the Dollar be Dethroned as the Main Reserve Currency?”, Global Economy Journal, Volume 9, Issue 3, Article 1.

17. Edwin L.-C. LAI and Xiangrong YU (2014), “Invoicing Currency in International Trade: An Empirical Investigation and Some Implications for the Renminbi”.

18. Menzie D Chinn (2012),:”A Note on Reserve Currencies with Special Reference to the G-20 Countries”, International Growth Centre, Working Paper 12/0350 May 2012.

19. Peter Bofinger (2011), “The Scope for Foreign Exchange Market Interventions”, United Nation’s Conference on Trade and Development, No. 204, October 2011.

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