Currency evaluation models: How are exchange rates determined?

Traders use a variety of ways to figure out the fair value of a currency. We will examine a few of the currency valuation models that exist, below on this page.

First of all, what gives a value to a currency? Money is valuable if it functions as an efficient medium of exchange and a store of wealth. The euro, for example, serves both functions.

Globally, we know that the euro represents 51% of foreign exchange reserves, 51% of international debt, 46% of global import invoices, 32% of foreign exchange turnover and 28% of global payments.

The dollar is close in terms of overall payments, but the euro is by far the most widely used currency in the world. Historically speaking, the country with the highest national income in the world has the world's reserve currency. But this can change over time.

Since the 1400s, we have seen the world's reserve currency shift from Portugal to Spain, to the Netherlands, to France, to England, to the United States and to Europe. As with empires, reserve currency status doesn't last forever.

world reserve currency

A reserve currency is defined as a large amount of money - usually held by sovereign debt denominated in that currency - that is maintained by central banks and other large institutional investors, such as traditional retail banks. and non-bank institutions, such as hedge funds.

Central banks use them primarily as reserves, which can influence their own domestic exchange rate. For example, selling reserves to buy their own currency will help that currency to appreciate in value against the currency sold. Large investors will invest in currencies to speculate - that is, to bet on the evolution of their prices - or to keep them as currency hedges.

Major currencies perform differently in different environments. For example, Australia's economy is still dependent on commodity exports, which increases demand when the economy is doing well.

Thus, the AUD is very procyclical. When the economy is doing well, the Australian dollar is generally doing well. When there are episodes of "risk reduction", the Australian dollar is usually sold.

On the other hand, a currency like Japan's JPY will do well in "risk off" periods, where risk is avoided (as the nation is a creditor country).

In other words, it has what is called a positive net international investment position, that is, net foreign assets are greater than net foreign liabilities - Japan lends more to the rest of the world than it borrows.

During times when the market is immune to risk, Japan may withdraw its overseas assets to be on the defensive, which increases the yen's value. It also doesn't have any dollar debt, nor a lot of debt denominated in a foreign currency (which can be dangerous, as they would have limited ability to control those liabilities).

The yen is also a common financing currency because its interest rate is slightly negative. Traders like to borrow yens to buy high yielding assets. This is known as "carry trade".

If you borrow at 0% and invest in something that gives you a 5% return, you make money on that spread. Ideally, you should also hedge the currency risk.

For example, you borrow yens in the spot market, you could hedge by buying yen contracts in the futures market (long on yens versus your local currency) to offset your currency risk.

Of the top reserve currencies, here is an interpretation of how each reacts to what's going on in the market and in the economy:

Main reserve currencies

So, if you're a Canadian trader, you might consider that if your home currency is as procyclical as it is, it might be a good idea to hold smaller amounts of yens and US dollars to offset some of the this exposure.

Here are the observed sensitivities of currencies to global trade growth. South American currencies are more sensitive to cyclical variations, as are currencies that rely heavily on commodity exports, while the yen is countercyclical.

The measured sensitivity of currencies


There are also alternative currencies (monetary support mediums and/or wealth holders that are not government backed systems).


Throughout history, commodities have been used as a means of payment and to store wealth. This was often either gold or silver. Oil could also be used a currency, as an asset that held some value, although neither it nor gold or silver are very effective as a medium of transaction.

Oil is much less efficient than gold because of the frequent material variations in demand. Tying a currency to a commodity-based system can also be excessively costly as it limits the amount of money and credit that can be created.

The value of gold reflects the currencies and reserves available in the world relative to the global gold supply. When a currency depreciates, the value of gold will tend to increase. For example, below we see its value versus negative-yielding debt.

Gold et negative yielding debt

Both the FED and the ECB trust gold as a reserve medium and large financial institutions see it as a hedge against the depreciation of standard fiat currencies.


Also known as cryptos, they still have a long way to go before they are accepted as viable reserves by all central banks or as currency hedges by institutional investors.

At present, crypto markets are a highly speculative activity and aren't yet sufficiently well established for high-level value creation purposes.

Bitcoins, the world's most popular cryptocurrency, are an attractive wealth storage alternative. Their supply is limited. Also, you can transfer them and even use them to make purchases.

But if you look at the sources of demand, the FED and the ECB aren't going to buy it as a reserve asset. Institutional investors don't like it as a currency hedge when real interest rates get too low.

Bitcoins are a speculative asset that traders primarily use for the medium to short-term. Furthermore, Bitcoins don't always perform well in crisis situations (such as the 2020-2021 virus situation).

As a speculative investment vehicle, Bitcoins are the first asset traders will want to sell for cash in hard times. Its diversification value is therefore pretty low.

When there's lots of money and debt creation, all of these liquidities have to go somewhere, so a lot of them go into riskier, more speculative investment types.

A currency has several basic features. It is:

a) a means of exchange,

b) a means to store wealth, and, most importantly,

c) the government wants to control it.

Bitcoins aren't really applicable to the first 2 categories since you can't easily buy stuff with them and they are too volatile due to their speculative nature.

And it's not the latter category since it isn't part of a larger bank-based network.

Regarding the latter point if Bitcoins become too prevalent, various governments are likely to use whatever regulatory means they have to try to prevent their use. (Even gold has been banned by governments throughout history, including in the United States from 1934 to 1974.)

This page, however, will mainly focus on national currencies.

Currency evaluation models

Below, we'll explore a few currency valuation models:

1) Real effective exchange rate (REER)

2) Purchase price parity (PPP)

3) Behavioural equilibrium exchange rate (BEER - I love this acronym!)

4) Fundamental equilibrium exchange rate (FEER)

Real effective exchange rate (REER)

The real effective exchange rate (REER) is determined as the weighted average of a country's currency versus a basket of other currencies. The weights are a function of a country's currency's relative trade balance in relation to each country in the basket.

The REER can be expressed as:

REER = (E(a) x P(a)*/P) ~ (E(b) x P(b)*/P) ~ (E(c) x P(c)*/P)


E = nominal exchange rate

P*/P = price level relationship

~ = "in proportion to"

It can also be expressed as follows:

TCER = ER^a x ER^b X ER^c x ... x 100


ER = the exchange rates of the various countries;

The exponents (a, b, c, etc.) represent the distribution of exchanges. For example, if a country does 15% of its trade with a particular country, the exponent would be 0.15.

A country's REER can be found by taking the bilateral exchange rates between itself and its trading partners, and then weighting them by the trade distribution associated with each country and multiplying them by 100 to form an index.

One of the implications of the formula is that if there is genuine currency depreciation, net exports go up.

This makes sense, because if a currency depreciates in inflation-adjusted terms, it makes a country's goods and services cheaper in comparison. This stimulates the demand for these goods and services and therefore exports increase, all other things being equal.

Conversely, when a real exchange rate increases, goods and services become more expensive, reducing demand, and leading to lower net exports.

This is why many countries that use an export model to develop their economy typically prefer it when their currency depreciates. However, those that focus on a pattern of consumption growth prefer to have a stronger or at least stable currency, as their currency can buy more goods and services in the global market.

It also means that some business relationships have more influence on an exchange rate than others.

For example, the EU has a stronger trade relationship with the USA - or more precisely with countries that use the dollar - than with South Africa.

When the dollar weakens against the euro, US exports to Europe become cheaper, as the euro can buy more dollars per unit. To buy US exports, European buyers (consumers, businesses, governments) need to convert their euros into dollars.

A change in the nominal EUR/USD exchange rate would have more influence on the REER models based on the USD and EUR than on the weighting of the South African real exchange rate, as South Africa is a much less important trading partner in terms of the volume of capital.

The dollar index (DX, published by the ICE) is a weighted basket of exchange rates.

Currently, the index has the following approximate % weights:

  • Euro (EUR): 59%
  • Yen (JPY): 13%
  • Pound (GBP): 13%
  • Canadian dollar (CAD): 8%
  • Swedish crown (SEK): 5%
  • Swiss franc (CHF): 2%

Purchasing power parity (PPP)

To compare economic productivity and living standards between countries, some analysts will look at a measurement tool called the purchasing power parity (PPP).

PPP is a way of looking at the relative valuation of different currencies by comparing the prices in different countries. The price comparison can relate to a specific good or a basket of goods.

It can be represented using the following basic formula:

E = Pa / Pb


E = exchange rate between 2 countries

Pa = price of the good in country A

Pb = price of the good in country B

Following this formula, two currencies are in equilibrium when the same good is valued in the same way in the two countries (while taking into account the relative exchange rates).

To fully understand the price differences between 2 countries, it is necessary to use a representative basket of goods and services, for example a basket that would represent the relative weight of a nation's buyers' expenditures. This requires the collection of lots of data. To simplify things, the UN and the Univ. of Pennsylvania established a partnership, called the International Comparison Program (ICP).

These 2 reports can have an impact on financial markets.

Many forex traders will also use PPP settings to help them find undervalued or overvalued currencies and to generate trading ideas.

Currency fluctuations can also influence the return of foreign financial security investments. A bond with a yield of 9% in a foreign currency and which suffers a corresponding decrease of 9% in that currency doesn't generate any real return.

Certain macro-accounting measures will allow the GDP to be adjusted according to PPP. This converts nominal GDP into a figure that makes it easier to compare countries with different currencies.

For example, let's say a specific Ralph Lauren shirt costs $200 in the US and €160 in Europe. In order for this comparison to be fair, we must take the exchange rate into account. Suppose the EUR/USD currency pair is trading at 1.27. This means that the European shirt costs the equivalent of $203.20.

When only taking account this shirt, the PPP between the two countries would be 203.20/200, or 1.016.

This means that if a European consumer wanted to buy the shirt for less, he or she could buy it in the US for $3.20 less. This would lead to a conversion of euros into dollars, which would cause the dollar to rise against the euro, all other things being equal.

Are there any drawbacks with the PPP model?

Before using the PPP concept in your trading, it's important that you understand its flaws. The PPP will be more or less valid depending on the situation.

Trade friction and transit costs

In our above shirt example, a European shopper might want to save $3.20 per shirt and just buy it in the US. This may not be possible due to factors such as shipping and transit costs.

There may also be import duties which make imported goods cost more in one country than in another. The free flow of business activities supports the validity of PPP; restricted activity will undermine its relevance.

There is an associated delay, which represents a "convenience cost"). Many will be willing to "pay" that $3.20 to receive an item quickly, rather than wait for a lengthy overseas shipment process.

Some goods are also not negotiable. Natural gas is produced and sold on the domestic market, as are medical services. Fruits and vegetables also can't be traded.

Input costs

With indexes such as the Big Mac Index, the item's "input" costs, such as labour, appliance maintenance, ingredient costs, etc. aren't always traded between countries. These costs are usually different from nation to nation.

Imperfect competition

The prices of goods typrically vary from country to country due to imperfect market competition. If a company has a significant competitive advantage in a certain market due to strong market power, it can keep commodity prices lower.

Due to imperfect competition, an eventual equilibrium in the prices of goods is unlikely to be seen.

Tax disparities

Taxes are another component that causes changes in capital flows.

Consumption and sales taxes, (such as California's 7.25% sales tax), can cause prices to be naturally higher in one region compared to another.

The quality of goods

Goods aren't always of the same quality level. Even seemingly comparable items (such as a Ralph Lauren shirt) may differ in quality from one nation to another.

Price levels

Countries have different baskets of goods that are representative of consumption patterns within their respective economies. As such, they will measure inflation rates differently.

The renowned Big Mac index

A popular form of PPP is the Big Mac index, invented by Economist magazine in the 1980s.

The Big Mac index was a bit of a joke at first. It is unrealistic to expect that the price of an average-tasting burger would contribute to an accurate representation of which currencies are worth what or how they might be misaligned.

But the idea is to take the price of a Big Mac in one country and divide it by the price of one in another.

The Big Mac is designed to make PPP exchange rate theory more fun and easier to understand.

The idea is that, in the long run, exchange rates should move towards an equilibrium that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries.

Accordingly, Economist proposes both a gross and a GDP-adjusted index.

The gross Big Mac index

The gross Big Mac index is based on PPP.

a) PPP implies that exchange rates are determined by the value of the goods that the currencies can buy.

b) Differences in local prices - in this case, Big Mac burgers - may suggest what the exchange rate should be.

c) Using the Big Mac price differences, you can simplistically determine how much one currency is under- or overvalued relative to another.

The GDP-adjusted Big Mac index

a) Changes in labour costs and barriers to trade and migration can undermine purchasing power parity.

b) To control for this, the adjusted index predicts what Big Mac prices should be given to a country's GDP per capita.

c) The difference between the expected price and the market price is an alternative measure of the currency's valuation.

Below is a sample of the January 2021 Big Mac index, adjusted for GDP per person. Of course, McDonald's charges more for their burgers in rich countries (e.g. Luxembourg) than in poor countries (e.g. Mexico). This measure is then adjusted according to income per capita income.

Big Mac index

It also gives individual estimates based on this consideration. For example, in England a Big Mac hamburger costs 22% less than in California, while the UK's GDP per capita is 17% lower than that of the USA.

If we take the difference between the two statistics, this suggests that the Brits' pound is nearly 6% undervalued against the USD.

British pound undervalued dollar

Here are the countries with the cheapest and the most expensive Big Macs, as well as those where the burger is earned the "fastest" and "slowest". In other words, how long would the average man or woman have to work in these countries to buy a Big Mac:

Big Mac prices

PPP vs GDP-adjusted indices

The GDP-adjusted index is supposed to compensate for the fact that one would expect the average price of a Big Mac to be cheaper in poor countries because labour costs are lower there (and the opposite also).

PPP helps indicate the direction that long-term exchange rates should take. For example, a country like China is getting richer. A trader can therefore use PPP to understand how the renminbi exchange rate has changed against other countries over time.

The PPP suggests that the USD/CNY exchange rate should decline over time as China's income increases. But the PPP says little about today's equilibrium exchange rate.

Therefore, the relationship between prices and GDP per capita may be a better guide to the current fair value of a currency as opposed to PPP.

The Balassa-Samuelson effect

The Balassa-Samuelson effect helps explain why prices of both goods and services are structurally higher in more developed countries than in less developed countries.

It is often thought that this this due to greater variation in productivity levels in the tradable goods sector (compared to the non-tradable goods sector).

In turn, this may explain the large difference in the price of services and wages between countries, as well as the differences between exchange rates and what the PPP suggests.

The implication is that the currencies that represent the higher productivity countries will appear to be undervalued in relative terms and that this effect will appear to be stronger as incomes rise.

According to the "law of one price", goods that are easily exchangeable should not exhibit significant price differences depending on their location.

In other words, the price of socks in France should theoretically be the same as in Canada despite the large gap in GDP per capita. Both Canada and France will be motivated to buy from the lowest cost producer.

On the other hand, most services (ex: car washing, haircuts, foot massages, etc.) must be obtained locally.

This makes their prices very specific to where they are provided. In addition, some goods, such as grand pianos, have high transit costs - and may be subject to import duties - so the prices of these types of tradable goods also vary from country to country.

The Penn Effect states that these higher price levels structurally go in one direction - that is, higher income countries will consistently see higher prices for services and goods with low value-to-weight ratios (e.g. beds, washing machines, clothes dryers, etc.).

The Balassa-Samuelson effects also suggest that an increase in wages in the tradable goods sector will also tend to lead to wage increases in an economy's non-tradable service sector.

Salary increases are generally higher in emerging markets where they have more catching up to do technologically, and therefore higher productivity rates. These increases also lead to structurally higher inflation rates there than in more developed economies.

Ultimately, differences in income and wages are mainly due to productivity differences between workers. Sectors with low productivity gains are also those most affected by non-tradable goods, such as painting services. This has to be true, otherwise this type of work would be outsourced abroad (and obviously some types of work cannot be outsourced).

Some jobs are less sensitive to productivity improvements than others. For example, a hairdresser in California is usually no more productive than one in Spain.

But these types of jobs have to be performed locally. So even though Californian workers collectively are more productive than those in Madrid, the equalisation of local wage levels means that Californian hairdressers are paid more, on average, than Spanish hairdressers.

In other words, local (non-tradable) goods have different prices depending on the jurisdiction and will tend to be more expensive in richer countries and cheaper in poorer countries.

Tradable goods will have more or less the same price in all countries, although this depends on transit costs, trade barriers, taxation and other factors.

It also means that the tradable goods sector has a greater influence on a country's exchange rate compared to non-tradable goods. Indeed, when a country wants to buy from another country, it has to exchange currencies, which influences supply and demand.

If a French buyer wants to buy something from Canada, he has to convert his euros into Canadian dollars. The CAD is then stronger than the EUR.

Behavioural equilibrium exchange rate (BEER!)

The BEER approach attempts to measure the misalignment of exchange rates between two given currencies based on transient factors, random disruptions, and current economic fundamentals relative to their sustainable levels. The BEER approach is often used using econometric applications and can be used to explain cyclical changes in money.

The choice of variables for the BEER approach is discretionary, based on available data as well as beliefs about what affects an exchange rate. This may include the following:

- monetary policy and its probable future evolution / nominal and real interest rate differentials

- the terms of trade (prices of imports and exports between countries)

- national savings and savings strategies

- productivity gaps

- debt and equity securities (and the risk premiums that exist between them)

- demographic considerations and their net effects on savings and other forms of economic behaviour

- net foreign assets compared to net foreign liabilities

- fiscal policy and its probable evolution

- foreign exchange reserve levels

- the capital account policy

- net external debt as a % of production

- the prices of both traded and non-traded goods

- tariffs, import duties, non-tariff barriers and other similar macroeconomic factors

Some might also take into account qualitative factors such as the outcome of an election or political action (e.g. the Trump-Biden election outcome), but these are largely influenced by expected changes in macroeconomic variables as a result of these events.

For example, the presidential election awarded to Joe Biden had an impact on the way traders viewed the evolution of personal and corporate tax rates. This had an impact on capital flows.

If tax rates are increased, for example, more capital is expected to flow out of the United States. It could also decrease consumers' take-home pay and decrease the national savings rate.

If higher corporate tax rates also discourage companies from investing, this would have negative effects on productivity.

It could also lead to a widening of the fiscal deficit (if the additional income produced does not offset the expenditure and translates into higher tax revenues) and lead to the need to sell an unsustainable quantity of bonds abroad (a promise to deliver currencies over a certain period).

This is an example of a BEER econometric approach to determine the fair value of different exchange rates.

Fundamental equilibrium exchange rate (FEER)

A Fundamental Equilibrium Exchange Rate (FEER) is similar to how the term is used with respect to the valuation of other asset classes. What is the fundamental equilibrium exchange rate based on existing policies?

In the realm of currencies, the fundamental value should be that which is supposed to generate the current account of a surplus or deficit equal to the nation's underlying capital flow.

This assumes that the country seeks to achieve an internal equilibrium and doesn't limit trade or capital flows to keep its balance of payments at a certain level.

For example, if a country wants to anchor its exchange rate, it must either give up an independent monetary policy (if it wants to allow capital to flow in or out as needed), or restrict its capital account if it wants to continue to have autonomy over its monetary policy. (This dynamic is commonly referred to as a "trilemma".)

As productivity and aggregate production tend to increase over time, this increases countries' reserves.

The secular growth rate of reserves also gives an indication of the amount of foreign capital that might be available to finance the current account deficit of countries that have one (e.g. Mexico, France, Brazil, New Zealand and Spain).

Because capital is mobile, it is difficult to determine what a country's underlying capital flow is.

It would be dangerous for a country to assume that a budget or current account deficit, no matter its size, could always be financed by external capital (by selling debt to foreigners). This would completely nullify the concept of a fundamental equilibrium exchange rate.

Borrowing heavily (a form of capital inflow) and lending heavily (a form of capital outflow) can be economically dangerous and unproductive.

A FEER should be defined in real terms (i.e. adjusted for inflation). A country that experiences an inflation rate that is 5% higher than that of other countries means that its currency will have to depreciate by 5% in order to benefit from the same competitive position as before.

In other words, a 5% depreciation will give citizens the same set of choices as before and producers who have to sell their goods will have their competitiveness restored internationally.

The exchange rate considered is also not a bilateral rate in the sense that "the EUR/USD exchange rate is 1.22", but rather an effective rate.

In other words, the other countries are taken into account and weighted according to their share in the foreign trade of the country in question. This then feeds into the estimate of the global exchange rate which measures an overall competitive position.

It is misleading to measure a country's "exchange rate" as one that only takes into account the currency of a single trading partner, assuming that a country's trade is conducted with other countries.

It may be difficult to find the FEER for those countries that depend heavily on the export of a certain good such as avocados and on their particular national savings strategy.

For example, Spain is an avocado-exporting country that mainly converts its savings into foreign assets. Another avocado-exporting country such as Mexico is not saving as aggressively.

Therefore, Spain can be expected to be less sensitive to a drop in the price of avocados than Mexico.

Under normal circumstances, avocado prices will have a significant influence on the exchange rates of these particular countries. For non-avocado-exporting countries, the sustainable level of a country's current account will be the most influential long-run structural factor that will impact the equilibrium exchange rate.

It is commonly accepted, although a bit arbitrary, that countries should not have current account deficits greater than about 3% of their GDP.

To finance this deficit, countries will have to finance it through debt.

Keeping this in mind, it is believed that since deficits and surpluses are a zero-sum game, this rule should apply symmetrically to countries with positive current accounts.

Partly for this reason, the deliberate depreciation of a currency (which makes exports relatively cheaper internationally and contributes to a more positive trade balance) is frowned upon.

Some macroeconomists suggest that a surplus/deficit situation of +/- 3% can be overcome as long as surplus countries do not increase their net foreign assets relative to GDP and deficit countries decrease their net foreign assets relative to GDP.

How did this "3% rule" come about?

In the past, academics and market practitioners identified ~40% as an approximate external debt to GDP level that shouldn't be exceeded.

Empirically, this tended to increase a country's vulnerability to default. If the growth rates in emerging markets are 4% in real terms and 7% in nominal foreign currencies (and 6% in nominal US dollars), that 40% multiplied by 6-7% gives a value falling somewhere between 2.3%-2.9%.

And this assumes that the deficit is financed using the domestic currency, where rates and payments can be controlled, unlike if the deficit is denominated in foreign currency.

These 2.3%-2.9% represent the theoretically viable level of deficit. As growth and inflation were somewhat higher in the past, this led to a higher equilibrium estimate of the sustainable current account deficit.

It differs from country to country. Some countries have structurally higher growth and inflation rates and will also depend on the country's net foreign assets position.

If a country earns more on foreign assets compared to what it pays for its liabilities, this additional income generated can support a higher deficit.

Reserve currency countries also have the advantage of being able to sell their debt to the rest of the world compared to a non-reserve currency country. Although the US has a balance of payments problem with a budget deficit and a current account deficit, the dollar is the most used currency in various functions, so there is a strong foreign demand for this currency.

Thus, the US can maintain its structurally higher deficits compared to a country that experiences economic and political instability, less robust institutions, higher levels of corruption, less support for commercialism and innovation, less internal investments, inadequate development of capital markets, etc.

Nevertheless, the US is a country that is only expected to experience nominal growth of around 3.4% (real output plus inflation) in the future, with real output of around 1.6% and inflation standing at around 1.9%. The breakdown of actual production is shown below:

real production ventilation

With its global reserve currency status, the US has the advantage of being able to run a larger current account deficit simply because it can easily sell a large chunk of its debt to other countries.

The US does benefit from an income effect and that is why its GDP per capita is higher than that of similar countries, such as France, England and Canada. Since the end of WWII, the real GDP per capita of France, England and Canada has stabilised at around 75% of that of the US. The dollar's influence played an important role in this regard. Indeed, it can benefit from a higher standard of living, which makes it important to have a reserve currency.

But this debt issuance amount has its limits. The US has an external debt-to-GDP ratio of around 46%.

If nominal growth is only 3.4% in the long run and we assume that the US will struggle to sell even more of its debt to foreigners who already have around $55% in dollar reserves, this means that current account deficits of over 1.7% will be hard to maintain.

The more the US is slack in its spending, the more it endangers the USD's status as the world's leading reserve currency. In the short term, that's no big deal. The US has the highest national income, which generally gives it the status of the first reserve currency. But it is a problem for the coming decades.

General overview

Apart from examining current macroeconomic data on growth, inflation, trade deficits, budget deficits, prices of different baskets of goods and services, it is important to have a good grasp of the big picture.

Examining the details can hide important information about changing trends and it doesn't spot everything.

For example, you can look at the fundamental situation of many developed countries and find that they appear to be financially poor. Yet their currencies are quite strong.

It is therefore important to understand the state of reserves and how unproductive spending, which leads to the creation of extra debt (and money needed to cover it), can sometimes help a currency in the short term.

The influence of reserves on the evaluation of a currency

Reserve currencies are a popular savings vehicle for investors. All great empires have had a reserve currency, as their productivity has led to trade with other countries. To facilitate this, they used their currency internationally.

They acquired wealth, geopolitical power, and military might to defend their trade routes. They developed strong capital markets and a financial center that helps attract and distribute capital. All of these help to strengthen the use of a reserve currency.

Naturally, the demand for a currency on a global scale (through the purchase of a country's assets) helps to increase its value.

This also allows them to borrow more to increase their income and live beyond their means. But this borrowing and strained financial situation also contributes to the eventual decline of an empire.

Debt is a promise to repay money over time. When countries take on too much debt, it means they have to create even more debt and money to service it (i.e. to pay the interest on this debt). It also means that more people want to get out of debt AND its related currency and move their wealth elsewhere.

Policy makers come to a point where they have to reach a compromise between:

a) allow interest rates to rise to unacceptable levels as part of a typical currency defense strategy (i.e. compensating investors enough to hold it), or

b) "printing" money to buy debt, which further reduces the value of money and money-denominated debt.

Faced with this choice, central banks almost always choose option B for printing money, buying debt and devaluing the currency. It is the most discreet way out of financial problems and therefore the most politically acceptable option. Both the US and Europe are very guilty of this as of this writing.

But this process usually continues in a self-reinforcing fashion because the interest rates charged on money and debt are not enough to induce investors to compensate them for the currency's depreciation.

This process will continue until the point where money and real interest rates establish a new balance of payments equilibrium.

In other words, this means that there will be enough forced sales of financial assets, goods and services and enough restricted purchases of these by domestic entities to the point that they can be paid for with less debt.

And this usually translates into the loss of most of a currency's reserve status. For example, even though the British empire's peak passed centuries ago, the pound still represents about 4.5% of the world's reserves.

Global reserves

Today (March 2021), global reserves - that is, the share of central bank reserves by currency - look like this:

- USD: 52%

- EUR: 19%.

- Gold: 13%.

- JPY: 7%

- GBP: 6%.

- CNY: 3%.

These relative weights are a function of the following main elements:

a) the fundamental elements that influence their relative attractiveness and

b) the historical reasons for the use of these currencies.

The dollar, for example, still represents over half of world reserves. This is more due to its reputation than its fundamentals.

Reserve currency status is one of the last things an empire loses once it has declined in relative terms. It lags behind a country's fundamentals because it isn't easy to change a well-established system. And it's very similar to the way languages ??last over time.

The Portuguese and Spanish Empires declined hundreds of years ago, but languages ??are passed down from one generation to another, meaning that languages ??originally spoken as a result of conquest endure for very long periods.

The UK empire established the American colonies (and provided them with a language), which eventually broke away from the US and became the world's first superpower. This gave birth to a large number of English speakers, who persist today thanks to the technologies and ecosystems produced by US companies such as MeWe, Google, Microsoft and IBM.

Furthermore, currencies are like languages ??in terms of social effects. The 4 biggest reserve currencies (USD, EUR, JPY and GBP) are now in place because they represent the major empires after the post-war period. However, on a fundamental level, they are not that attractive.

The relative reserve holdings of each currency are irrelevant to the proportions you would like to have to achieve balance and be in line with the direction the world is moving towards.

For example, China represents a larger share of the world's economy in terms of aggregate mass and its exchange rate, and it is undervalued relative to its position in relation to world reserves.

The dollar, euro, yen and pound are widely used as they arose from the former G5 group of nations, which were also the top countries in 1970 in terms of GDP per capita (US, Germany, France, Japan, UK).

The fundamental principles of the reserve currencies

We'll take a brief look at the fundamentals of each of the above mentioned reserve currencies, including gold. As a long-term store of value, it acts more like a currency than a commodity. Knowing the basics can help you better understand the big picture and separate the short term from the long term.

US dollar

Based on a long-term analysis, the relative proportion of USD in global reserves will likely decline over time, due to:

i) The size of the American economy relative to the global economy.

ii) The size of the capitalization of American debt markets relative to the capitalisation of debt in other markets.

iii) The allocation of assets that foreign investors would want to hold in order to balance their portfolios in a prudent manner (namely: less dollars).

iv) The reserves that should be held to meet the needs of trade finance and capital flows.

For example, the United States now accounts for about 19% of the world economy, but over 51% of world reserves.

The euro

The euro is a kind of pegged monetary union. One of the main advantages of a unified European currency is that it helps not only to facilitate trade, but also to build up a global reserve. This can help Europe borrow more cheaply and increase its overall income.

But the euro is a weakly structured currency because it unifies the monetary policies of many countries which exhibit highly variable economic conditions.

As each country is bound by the ECB's monetary policy, they have a limited capacity to conduct monetary operations according to their own economic situation.

This creates a currency that is too weak compared to stronger economies (such as Ireland) and a currency that is too strong compared to weaker nearby economies (such as Spain). This creates disparate economic outcomes and more social friction.

European countries are highly fragmented on a number of different issues and the region is relatively weak economically, geopolitically and militarily.


Gold is a popular reserve asset because it has worked for so long. Its history goes back thousands of years.

It is not based on a fiat system, so it is an asset that isn't credit-dependent and there is no risk of it being excessively "printed", unlike traditional currencies.

Prior to 1971, during the Bretton-Woods monetary system (and in many other prior empires and economies), gold was the basis upon which money was built. Each currency represented a certain quantity of gold.

When claims on silver become excessive and gold reserves are no longer sufficient to meet all obligations, policymakers change convertibility or completely eliminate the parity with gold.

This type of dynamic is still in play today. Gold generally receives inflows when valuable financial reserves yield less in inflation-adjusted terms, as this means that the natural credit cycle is running out of room in the traditional way. Money must therefore be created in order to fill this gap.

The value of silver in gold terms decreases and that of gold increases in monetary terms.

The gold market is small and relatively illiquid. Therefore, its use as a reserve asset is accordingly limited.

Gold isn't a plausible alternative to turn vast amounts of debt wealth into only about one percent of the size of global debt markets. However, its price could vary considerably in the event of such a move.


Japan's yen suffers from the same domestic financial problems as the USD. The debts are too high in relation to the income. Therefore, this means that the central bank is buying a lot of rapidly increasing debt to enable it to pay very low nominal and real interest rates.

Furthermore, Japan isn't a major economic and military power. Its economy represents around 6% of global GDP and it loses market share over time as its labour force and overall population decline.

The yen is also not widely used or stored outside of the country.

British pound

Before America's dollar became the world's reserve currency, there was the British empire, which overtook the relative strength of the Dutch empire nearly 300 years ago.

The UK represents only 2.9% of world GDP and has a double deficit (budget deficit and current account deficit). It also has relatively weak geopolitical power.

Its proportion in world reserves is another example of how reserve status tends to persist long after the relative influence of an empire has declined.

Chinese renminbi / yuan (RMB / CNY)

The Chinese Renminbi (or Yuan) is the only major reserve currency that is under-held based on its fundamentals.

Of all the world's economies, the Chinese hold the largest share of world trade.

Its economy is one of the largest and is expected to become the largest one during the first half of this current century. It is already richer than America in terms of assets.

The CNY has been managed to be roughly stable against other national currencies and on the basis of purchase price parity (we discussed this earlier).

Its foreign exchange reserves are also important. (The US, however, has low levels of foreign reserves).

In addition, unlike other reserves, it does not have a 0% or negative real interest rate.

China has a debt problem: its growth is faster than its income. But these debts are denominated in yuans when it can be controlled by restructuring (by changing the interest rates paid on the debt, by changing the due dates, and/or by changing the balance sheet on which it appears).

And China also doesn't have the debt monetisation issues that other nations have (thanks to its adjustable yield curve). In other words, its short and long term rates are always significantly above zero.

The main disadvantages of the CNY are:

i) It is not widely used globally.

ii) China lacks the widespread trust of global investors, especially with its unique form of top-down governance ("state capitalism") compared to Western democracies which have a more bottom-up governance style.

iii) Its capital markets are not yet fully developed and Shanghai and Shenzhen aren't considered global financial centres yet.

iv) Its payment clearing system is not well developed.


Summary of the currency evaluation models

There are 4 primary currency valuation models that traders look at:

1) Real effective exchange rate (REER)

2) Purchase price parity (PPP)

3) Behavioural equilibrium exchange rate (BEER!)

4) Fundamental equilibrium exchange rate (FEER)

The REER is defined as the weighted average of a country's currency against a basket of other currencies. A country's REER can be calculated by taking the bilateral exchange rates between itself and its trading partners, and then weighting each exchange rate by its trade balance (as a %).

PPP suggests that exchange rates should equalise over time such that tradable goods between countries become equal in price. For example, if a coat costs €20 in France and €30 in Canada, this suggests that Canadian consumers will want to purchase the shirt in France (which will convert CAD to EUR), which will cause the euro to appreciate and the CAD to depreciate.

Problems with PPP measurements include the distorting influence of structural and idiosyncratic factors between countries, such as trade frictions and transit costs, the costs of non-tradable inputs, imperfect competition, tax disparities, the quality of goods and price level measures.

BEER uses an econometric approach to measure exchange rate misalignment between currencies based on temporary influences, random events, and current measures of economic fundamentals relative to long-term sustainable levels. It is often used to explain cyclical influences in money.

For example, in the United States, the US Treasury records an influx of revenue every year. It takes liquidity (i.e. cash) out of the economy as people and companies pay taxes. Less cash in circulation increases the value of the dollar, so nothing is lost.

FEER uses the concept of fundamental equilibrium value. For example, if a country has a deficit in its balance of payments (the combined current account and budget account are negative), can it plausibly finance this deficit by selling debt to foreign investors?

Reserve currency countries that issue debt in their own currency when there is strong external demand may be more successful at it than emerging market countries.

Emerging countries that issue foreign currency debt (usually because they carry lower interest rates and their value is more stable than that of their own national currency) will face issues if their currency depreciates in relation to the currency in which a large part of their liabilities are denominated.

Currencies with structural balance of payments surpluses often see their currencies appreciate, as this indicates excess demand for that currency on the international market.

All of these models assume floating exchange rates.

When there is a fixed exchange rate, the central bank or broad monetary service largely controls the exchange rate by buying and selling in the open market.

Some other monetary regimes are what one might call "managed" regimes. In other words, they are not floating or fixed, but held in a desired range for a certain time. The yuan is one example.

In terms of policy choices, a country will have to fix its exchange rate either by controlling the flow of capital into and out of the country (through banks, non-bank financial institutions for example), or by forgoing the use of an independent monetary policy.

For example, if a country wants to peg its currency to the US dollar and does not control its flows (because it doesn't want to or because it doesn't think it can), its own monetary policy will be dictated. by the US FED.

This keeps the interest rate differential relatively constant. When one currency earns more or less against another, it makes the currency more or less beneficial to hold.

A fixed exchange rate may also be possible when capital flows between countries are so low that managing an exchange rate is relatively easy without the flows subjecting it to large demand variations.

This is in part what made the Bretton Woods monetary system effective from 1945 to 1971.

Even though there are various fixed exchange rates around the world - for example, the Hong Kong dollar to the US dollar (USD/HKD) - these currency pairs are still tradable. They should not be expected to move a lot, unless the tie is broken.

Ultimately, any tied systems that are not compatible with the fundamentals of the currency will eventually fail.

Summary - Interest rate forecasts according to economists

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