FIN502 Case Study 1: US Dollar, Mexican Peso, Indian Rupee (Essay Sample)

FIN502 Case Study 1
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FIN502 Case Study 1
Introduction
For a long time the US dollar (USD) has been the dominant international currency, alongside the Euro, the British Pound, and the Japanese Yen. These four currencies constitute more than 95% of the total global currency reserves and are the major currencies for international transactions (Maziad et al., 2011). Nonetheless, a major shift has been observed in the last few years. Emerging market (EM) currencies such as the Mexican Peso (MXN), the Brazilian Real (BRL), the South Korean Won (KRW), the Indian Rupee (INR), and the Chinese Yuan Renminbi (CNY) have become increasingly popular in the international scene. Against the backdrop of robust economic growth in China, the Renminbi has particularly gained immense popularity, with some analysts arguing that the Chinese currency could soon overtake the USD to become the next top reserve currency (Frankel, 2011; Maziad et al., 2011; Prasad & Ye, 2012). Though there are still some challenges, the validity of this argument cannot be underestimated.
This paper discusses the growing role of EM currencies in the international economy. The paper specifically examines the extent to which the Euro has affected the popularity of the US dollar as a medium of exchange and the potential of the Renminbi replacing the US dollar as the world’s most popular currency. Also, the paper considers whether the exchange rates of the Mexican Peso and the Indian Rupee are determined in a fixed or in a floating exchange rate system. Finally, attention is paid to the extent to which EM currency trading is risky. The paper concludes with recommendations for international market currency investors.
Has the Euro Affected the Popularity of the USD?
One of the factors that have affected the popularity of the USD is the euro. Formally introduced in 1999 (Pollard, 2001), the euro is the official currency for the Eurozone (19 of the 29 EU states) as well as a number of other European countries and overseas territories of EU member states. The euro is the second most popular international currency (in terms of reserves and international trade) after the USD. By 2002, the euro had totally substituted previously used currencies in the initial Eurozone countries. Monetary unification in Europe marked the entry of a new international currency (Neaime & Paschakis, 2002). With the introduction of the euro, the USD would now compete with the euro as a medium of exchange in international transactions, a unit of account, a store of value, and as the preferred currency in central bank reserves and financial asset markets.
Close to two decades since the introduction of the euro, the popularity of the USD as a medium of exchange has reduced remarkably. For instance, the proportion of dollar-denominated bonds in the international bond market today is lower than it was prior to 1999. Additionally, the share of central bank reserves and international trade denominated in euro and other non-US currencies has been on the rise. In essence, there has been progressive diversification away from the USD over the years.
The dramatic popularity of the euro was facilitated by three major factors: economic size, financial market development, and macroeconomic stability (Neaime & Paschakis, 2002). The eurozone is as large as the US in terms of economic size, the volume of trade transactions, and population. This played a crucial role in the internationalisation of the euro. Further, at the time of the introduction of the euro, the eurozone had a well-developed financial market, significantly free of capital restrictions as well as impressive inflation performance that would maintain the stability of the currency (Pollard, 2001). On the whole, while the USD remains the number one international currency, the euro has considerably reduced its popularity. The euro has not overtaken the USD like the USD did to the pound in the 1970s, but it is a plausible rival.
Will the Renminbi Replace the USD?
The USD faces competition from not only the Euro, but also EM currencies, especially the renminbi. In the last few years, the renminbi has made tremendous progress in terms of internationalisation (Frankel, 2011). For instance, a renminbi bond market has dramatically emerged in Hong Kong. Additionally, Chinese international transactions are increasingly being denominated in the renminbi. Foreign central banks have also contributed to the internationalisation of the renminbi by reserving the currency. With these developments, it has been predicted that the renminbi could become the number one international currency by 2020, replacing the USD (Maziad et al., 2011; Prasad & Ye, 2012).
According to Frankel (2011), the possibility of the renminbi overtaking the USD stems from two major factors. First, the size of the Chinese economy is set to surpass that of the U.S. in the near future. Indeed, economic size and a country’s share of global trade are major antecedents for a national currency’s accession to international status (Maziad et al., 2011). China today represents approximately 10% of the total gross domestic product (GDP) worldwide as well as about 9% of international trade (Prasad & Ye, 2012)
The second factor relates to the historical precedent when the pound was overtaken by the dollar (after World War 1) (Frankel, 2011). Compared to the dollar and other currencies that have attained international status, especially the yen and the mark, the renminbi has exhibited a rather different trajectory toward internationalisation. For the renminbi, the Chinese government has actively promoted its internationalisation – something the US, Germany, and Japan never did. In spite of reluctance on the part of government, the dollar, the yen, and the mark still attained international status. In addition to permitting renminbi-denominated bonds and the use of the renminbi in international trade transactions, the Chinese government has promoted the internationalisation of the renminbi by relaxing cross-border capital restrictions, allowing some banks to provide offshore renminbi deposit accounts, and establishing local currency bilateral swaps with central banks in other countries (Prasad & Ye, 2012). The enthusiasm the Chinese government has shown in pushing for the renminbi to become the number one international currency makes the Chinese currency more likely to overtake the USD.
Even so, there are challenges. First, it is not clear the extent to which China is willing to stop financial repression in its domestic financial system and to eliminate cross-border capital restrictions. If these two are not achieved, it may be quite difficult for the renminbi to overtake the USD as the top international currency. Fortunately, China’s capital account has increasingly become open, consequently raising the possibility of the renminbi replacing the USD (Prasad & Ye, 2012). Another challenge is that China still exercises tight management on its exchange rate (Prasad & Ye, 2012). For a currency to attain international status, its value must be market-determined. Strong financial market development is also a vital factor for currency internationalisation (Maziad et al., 2011). Compared to the U.S. and other countries whose currency have attained international status, China has a relatively underdeveloped financial market characterised by shallow bond markets (Prasad & Ye, 2012).
The Mexican Peso and the Indian Rupee: Fixed or Floating Exchange Rate System?
Other EM currencies whose popularity across the international scene has increased are the Mexican peso and the Indian rupee. Similar to China, Mexico and India have experienced tremendous economic growth in the last few years, setting the stage for the internationalisation of their currencies. Even so, achieving currency internationalisation in the scale of the USD, the pound, and the euro remains a major challenge for the Mexican peso and the Indian rupee.
One factor that often affects currency internationalisation is the nature of the exchange rate system. Generally, the exchange rate system may be fixed (determined by the government) or floating (determined by market forces). A floating exchange rate system is crucial for currency internalisation as liberalisation and openness are vital ingredients of international transactions. Mexico adopted a floating exchange rate system in 1994 following the devaluation of its currency (Authers, 2004). The adoption saw Mexico become the first EM to have a floating exchange rate system. The benefits of floating have been evident: e.g., economic recovery as well as stabilization of interest rates, inflation, and the banking system (Authers, 2004).
The Indian rupee is also determined in a floating exchange rate system. Nonetheless, India’s floating exchange system is not completely free from government intervention – the country uses what is known as a managed floating exchange rate system (Dua & Ranjan, 2010). This means that though exchange rates are determined by market forces, there is usually some level of intervention by the country’s monetary authority. This is not unusual as many countries around the world follow the same practice. Indeed, no exchange rate system is completely market-determined. During severe instability, governments usually intervene to restor...