What is Foreign Exchange?
There are several accepted Global/Reserve currencies viz USD, GBP, YEN, EURO etc. A country needs currency to settle Import/exports of goods and services and grants and subsidies in various forms. Besides countries keep Gold, SDR, Sovereign Debts, Treasury bills. Countries keep Foreign exchange in their vault to regulate exports and imports, meet expenses, repay withdrawing investors in case of war or emergency, settle loans, Investments, and goods & services bills;
Currency Composition of Official Foreign Exchange Reserve (COFER)
Why USD as an acceptable Forex
US constructed its Gold Repository vault at Denver Mint in 1935. The Gold stored at Denver Mint between Jan 1937 to June 1937 was 10947 metric tones and by March 1941 the Gold storage swelled to 19757 metric tones which was 65.58& of total US Gold reserves.
Prior to 1944 Bretton Woods agreement, most countries were on the gold standard. This also meant that all the countries were liable to settle their currency liabilities in Gold. In 1944, countries met in New Hampshire, and agreed to peg the exchange rate for their currencies to the U.S. dollar. US being having largest gold reserves that time, gave confidence to countries for backing their currencies with Dollar
IMF in 1969, created a monetary reserve currency to supplement existing money reserves of member countries created in response to the limitation of gold and dollars as mean to settle international account
Constraint in Supply of USD to meet increasing needs of the world
During 1970s, in order to combat inflation countries began demanding gold for the dollars. Rather than allow Fort Knox to be depleted of all its reserves, President Nixon in his controversial economic policies leading to stagflation, separated gold from USD pegging (already world’s top reserve currency at that time)
Concerns over US Deficit resulting in value of USD
in 2009, China and Russia raised concerns of intrinsic value of USD in case the inflation sets. US might print US Treasury to support its debts and its budget deficit.
They demanded for a new Global Currency not connected to individual nations and is relatively stable independent of characteristic change in individual currencies.
Yuan was awarded the status of reserve currency by IMF on 30th November, 2015. Yuan also found its place in Special Drawing Rights (SDRs) Basket on 1st October 2016. The other currencies forming part of SDR are Euro, Yen, GBP and USD. To be able to be able to freely trade as forex, Yuan must be free-float currency.
Is USD still a better bet
Answer is Yes, as the other countries hold 6.6 Trillion Dollars in their COFER and any devaluation in USD will lead to severe financial impacts on other countries. Therefore, it is in best interest of the other countries to keep faith in USD.
At the same time, it is important to note that the US Debt-GDP ratio has been continuously rising since 2007 and is at 108% in 2020. The similar ratio was observed in 1941 when World War ended. Since FED rates are very low, a ratio Debt-GDP ratio of 300% is considered as comfortable. This ratio at 50% can be alarming for other developing countries with higher interest rate.
Is Gold changing hands? Are we prepared?
An estimated above the ground 190,040 Metric Tonnes Gold exists in the world and 50,000 Metric Tonnes Gold still to be mined.
US Central Bank still number 1 in terms of holding Gold of ~8100 Metric Tonnes is almost halved since start of its Gold Repository in 1941. At the same time. India holds only 633 Metric Tonnes in 2019. While Germany, Italy, France, China, Russia holds sizable chunk of Gold reserves. India needs to evaluate its Gold reserve Position vis a vis its Forex reserves [refer graph 3]
Is increase in Forex a Euphoria?
India’s Foreign exchange reserves rose to all time high and are currently at 476 Billion USD. India’s COFER consists of 6.8% as Gold while rest 93.2% is in foreign currency, SDRs, and reserved position with IMF. The Gold reserve ratio is 16% for the top 20 countries. US Tops the list with 77% as Gold reserves.
Similarly, Net FDI Inflow of 529 Billion USD since 1998 till 2019 are valuing at 37 Lakh Crores as against their value of investment of 30 Lakh Crores Rupees. MTM liability of reduction by 25% due to dollar valuation. — Saving However, Gold value would have been more than doubled.
Of course, market equilibrium of increased demand and limited supply of Gold would try to set in. But then we should also remember that G7 countries hold big Gold reserves.
We have demonstrated that accretion of Gold inplace of USD would have doubled in terms of its current value. Whereas holding USD since 1998 gave us a saving of 25% due to MTM valuation of Dollar. Its time that we carefully evaluate our COFER in order to avoid any unforeseen USD valuation risk for our hard earned Foreign Exchange reserves.