History Of Systems Determining Relative Value Of Two Currencies

The smooth functioning of international trade required a universally accepted foreign currency to settle the internal trade and a way to balance the trade imbalances amongst countries. This led to the question of determining relative value of two currencies? Different systems were tried in past to arrive at relative value of two currencies. The documented history suggests that sometime in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20. This mechanism of valuing currency was called as gold standard. With further growth in international trade, changing political situations (world wars, civil wars, etc.) and situations of deficit/ surplus on trade account forced countries to shift from gold standard to floating exchange rates. In the floating exchange regime, central bank’s intervention was a popular tool to manage the value of currency to maintain the trade competitiveness of the country. Central bank would either buy or sell the local currency depending on the desired direction and value of local currency.

During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they can convert their currency into USD at any time and USD value will be pegged to value of gold. Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar. With adoption of this system, USD became the dominant currency of the world.

Finally Bretton Wood’s system was suspended and countries adopted system of free floating or managed float method of valuing the currency. Developed countries gradually moved to a market determined exchange rate and developing countries adopted either a system of pegged currency or a system of managed rate. In pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. Although in long run it is difficult to maintain the peg and ultimately the central bank may change the value of peg or move to a managed float or free float. In managed float, countries have controls on flow of capital and central bank intervention is a common tool to contain sharp volatility and direction of currency movement.