International Currrencies Made EZ: Glossary of Terms

by | Feb 12, 2000 | Archives, DO NOT USE - MC

Bretton Woods. The international meeting near the end of WWII, in 1944 at Bretton Woods, New Hampsire, where 44 nations carved out an agreement stabilizing world trade and pegging the price of gold to the United States dollar ($35.00 = 1 oz. gold). Also created at the meeting were the World Bank, whose role was designated as assisting developing countries (mostly Eastern European countries) secure finances, and the International Monetary Fund (IMF), whose role was to maintain stable exchange rates between countries. The Bretton Woods system, as it is now called, collapsed in 1971 when the United States removed dollar from the gold peg, allowing the dollar and all currencies to “float” against each other. Gold immediately jumped in price, since its value had been artificially suppressed by being pegged to the dollar. The value of the dollar began to decline at this point, because it was no longer tied to the stability of a precious metal.

Eurodollars. United States dollars held outside of the United States. Even dollars held in Asian, South American, and African countries are called Eurodollars because in the 1950s, 1960s and early 1970s, when stores of dollars piled up outside the country, most were held in industrialized European countries. The stockpiling of U.S. dollars outside the country developed as more and more dollars were sent overseas for a wide variety of purposes: payments for goods and services purchased, investments, foreign aid, etc. Countries tended to use dollars as their own reserves because many commodities (such as oil) were purchased internationally with dollars. Before 1971, each of these dollars were theoretically redeemable in gold from the U.S. treasury. For many years after Bretton Woods, foreign governments did not bother to redeem gold with their dollars, because they were, literally, “as good as gold.” But with the glut of Eurodollars in the 1960s, foreign governments and banks became nervous, fearing that there was not enough gold to back all U.S. currency. As a result, many dollars were exchanged for gold, and U.S. gold reserves dropped sharply. Eventually, the U.S. announced that the dollar would no longer be redeemable. The massive amounts of Eurodollars were too threatening. At first, many governments seemed not to mind that the dollar was no longer redeemable. But the U.S. kept the printing presses going, and soon the value of the dollar began falling on foreign exchange markets.

Petrodollars. Dollars sent to Oil-Producing Nations (mostly Arabian) in payment for oil during oil-price surges of the early and middle 1970s. The price of oil rose 76.6% in 1973, and 139% in 1978-1979. Billions of dollars were sent out of the country to pay for oil from Arab countries. This phenomenon has been called the greatest shift of wealth in the history of the world. The Arabian countries had relatively little other business activities, with no place to put the dollars to work. So they sent the dollars back to be deposited in large United States and European banks. The banks had trouble lending these “Petrodollars” because U.S. and European business was in recession caused by the rapidly-rising oil prices. Developing countries, hard hit by rising oil pricess, were more than anxious to borrow large sums of these petrodollars at high rates of interest. Soon it became evident that many of these countries would not be able to repay these loans — or even the interest due on the loans. The banks refinanced the loans, then loaned the countries additional funds to make their loan payments. Finally, the situation deteriorated to the point that many of the largest U.S. and European banks have more out in loans to developing countries than the banks have in stockholders’ equity. This debt crisis is one of the banes of modern economics, because massive debt default by the developing countries could greatly reduce U.S. bank reserves, hindering their ability to make loans and thereby crippling the U.S. economy.

Key Currency. The central currency of the world, which is used as reserves by many countries and in which many international commodities (such as oil, gold, steel, etc) are bought and sold. Before WWII, the British Pound was the world’s key currency. Since the war the U.S. dollar has been the key currency. But with the severe loss of value the dollar has been experiencing, many economic experts say that the world is actually in search of a new key currency — probably the German mark or the Japanese yen.

Currency. Something of value that is used for exchange for goods, services, and other units of value. To be used as money, a currency must be: 1. acceptable by both parties in a transaction; 2. portable; 3. divisable and uniform in quality; 4. Ideally, it should have some intrinsic value, or be useful in itself; 5. scarce; 6. durable. Currency may have some tie to a scarce precious commodity, such as gold or silver, or have no tie whatsoever with a precious commodity.

Fiat money. Coin or currency that is not convertible to precious metal. Webster’s defines the word fiat as “A decree, order, or sanction.” Issued by governments, it has value only because it is declared to be money by government decree, and because it is agreed to have value by all involved individauls, businesses and governments. When a government issues too much fiat money, the value falls and inflation results. Almost all currencies in the world today are fiat money not backed by silver or gold. Thus, the story of modern economics is the story of many different currencies all inflating at different rates, with the U.S. dollar falling faster than most.

Central Bank. A central bank is an institution responsible for the creation and control of the money supply of a country. This institution can be government-controlled, quasi-government controlled, or privately- owned (as the United States Federal Reserve). The central bank of Great Britain is the Bank of England; of Germany the Bundesbank; of Japan the Bank of Japan. Central banks literally create money out of thin air as you will see in the explanation of fractional reserve banking.

United States Federal Reserve. “The Fed,” as it is often called, is a privately-owned organization chartered by the U.S. government. It creates and maintains the U.S. monetary supply by buying Treasury certificates, loaning money to banks, and designating interest rates. On a daily basis the Fed decides if it wishes to add to the U.S. money supply. If it does, it buys U.S. Treasury securities directly from the government or from major banks and brokerage companies. To pay for these securities, the Fed writes a check on its own account — but in reality it has no assets in its account, other than the assurance of the U.S. government that it will pay the bearer of the securities in full. In effect, the Fed has created money with the stroke of a pen (or a computerstroke, to be more accurate). The Fed also makes direct loans to U.S. banks, charging them a specific interest rate (discount rate) that determines the rate banks charge customers for loans. When making such loans, the Fed, again, simply writes a check, creating money with the stroke of a pen.

Discount Rate. The interest rate charged for loans made by the Fed to U.S. banks. This rate greatly determines U.S. interest rates in general because when loaning to customers banks tend to charge an interest rate slighly above the discount rate. For example, if the discount rate is 7%, banks must pay the Fed 7% when borrowing money. Thus, when loaning money to customers, banks would charge a point or two above 7%. When the Fed raises or lowers the discount rate, banks in turn raise or lower interest rates accordingly on loans charged to customers.

Fractional Reserve Banking. An economic system for creating money. Banks receive money in several different ways: through deposits by customers, sales of assets, and loans from the Fed (as described above). These funds become reserves, upon which the bank can loan money to businesses and private consumers. The Fed establishes reserve requirements, stating that the bank must hold a certain percentage of its reserves, but can loan the rest. This reserve requirement is usually about 10%.

As an example, say that a bank receives a loan from the Fed in the amount of $100 million. The interest charged (the discount rate) is, say 7%. Based on that, the bank will charge customers anywhere from 8.5% to 11%, based on their credit rating, standing with the bank, etc. If the reserve requirement is 10%, then the bank can lend out $90 million of the $100 million, keeping only $10 million in reserves.

The $90 million loaned out might be in the form of business loans, car loans, mortgages, consumer loans, etc. Each loan is made in the form of a check made out to the business or individual receiving the loan. Quite often these checks are deposited back into the bank making the loan, and based on those funds, When these checks are deposited into other banks (or back into the bank issuing the loan), the entire process starts again. Each bank is required to hold only 10% of its assets in reserve. It then loans out the other 90%, which is deposited into other banks, and so on ad infinitum.

This process continues until the original $100 million has grown to allow dozens or even hundreds of banking institutions to create $900 million. And remember, the original $100 million was created out of thin air by the Fed. The only thing standing behind the original $100 million is the promise of the Federal government to pay it back. In other words, the only thing standing behind the creation of any money in the United States is the ability of the government to raise money in the form of taxes.

Gross Domestic Product. (GDP) The sum of private consumption, investment, government expenditure, net stockbuilding and the surplus of national exports over imports.

Gross National Product. (GNP) GDP plus any excess of investment income from abroad less investment income owed to foreign governments or individuals. The GNP represents the production growth of a country and is usually expressed as a yearly percentage. Thus, a GNP growth of 3% for a particular year means that a country’s total economic productivy for the year increased 3% over the previous year.

Money Supply. The rate at which money is growing in a country. If the money supply is growing faster than the GNP, inflation will result. If the percentage of money-supply growth, less the GNP percentage growth (money supply % – GNP%), in one country is higher than in another country, the currency in the country with the higher percentage will eventually weaken compared with the other.

For example, if a country has a money-supply growth of 8% and a GNP growth of 2%, one could expect 6% per annum inflation. (This, of course, has other variables factored in.) This currency would lose value when compared with another currency that has, say, a 2% money-supply growth and 2% GNP growth.

How fast would it lose value? That can be calculated by comparing the money-supply percentage less GNP figures. Example: Country A has 6% annual money growth and 3% GNP growth. That means the currency of Country A can be expected to inflate at about 3% annually. Country B has 10% annual money growth and 1% GNP growth — or, by similar calculation, an expected inflation rate of 9%. Therefore, Country B’s currency is inflating at a 6% faster rate than Country A’s (9%-3%=6%). You can always find out how long it will take something to double by dividing the inflation rate (or interest rate) into 72. In this example, 72 divided by 6 (the difference between Country A and Country B) is 12. So Country B’s currency will lose one half its value versus Country A’s currency in 12 years.

In the above example, Country A’s currency will actually be worth 69.4% of its original value after 12 years. Currency B’s actual value will be 32.2% of its original value after 12 years. In reality, of course, currencies do not fall at the same rate year after year.

M1, M2 and M3. M1 is an often-used economic term that designates the sum of all currency in circulation plus all checking account deposits (short- term deposits). M2 designates the sum of M1 plus all savings account deposits (short-term time deposits). M3 is M2 plus all long-term deposits (CD’s).

To fully understand this, realize that when money is paid out of a checking account and put into a savings account, M1 is decreased and M2 is increased. When money is taken out of a savings account and put into a checking account, M1 increases — but M2 stays the same because M2 is the total of M1 and all savings deposits.

Beggar-Thy-Neighbor. When a country purposefully devalues its currency, or encourages its currency’s depreciation on foreign exchange markets in order to make products produced in the country cheaper in foreign countries — thereby increasing sales.

Example: Say that two countries, Singapore and Malaysia, have currencies that exchange at the rate of 1:1. Both countries produce raw rubber and trade back and forth, with a balance of payments equalling zero. But say that, hypothetically, Singapore allows its currency (the Singapore dollar) to inflate, until it’s worth only 50% of Malaysia’s currency (the ringgit). That means 1 Malaysian ringgit exchanges for 2 Singapore dollars, whereas before it exchanged for 1 Singapore dollar.

Before the devaluation, a ton of Singapore rubber sold in Malaysia for 200 ringgits. But after devaluation, the same ton of Singapore rubber sells in Malaysia for 100 ringgits. This is great for Singapore, because Malaysian rubber will still sell in Malaysia for 200 ringgits per ton. And in Singapore, Malaysian rubber will sell for 400 Singapore dollars. All other things being equal (quality of rubber, lack of trade restrictions or tariffs) this will obviously stimulate sales of Singapore rubber — both in Malaysia and Singapore.

Countries have undertaken beggar-thy-neighbor strategies since exchange rates were first used. Recently the United States expressely allowed its currency to weaken, in order to stimulate sales of U.S. products with Japan. U.S. officials hoped that the weakening dollar would encourage Japan to lower trade restrictions. The strategy did not work, but it was a classic example of beggar-thy-neighbor in the 1990’s.

Real Return. The actual spendable return of an investment, calculated by subtracting the consumer price increase from the total return paid by an investment. Real return is, in a way, synonymous with actual purchasing power gained from an investment. To calculate real returns from an investment, first find the paid (or accrued) earnings or growth of the investment for the period of time you wish to examine. Subtract the consumer price index increase for that same period of time. If you held an investment for three months, subtract the consumer price increase for the same three months. If you held an investment for one year, subtract the consumer price increased for that one year period.

Example: Say you hold a bond that returns 9.31% per year. You find that the consumer price index rose 3% for the year. (This rise in the consumer price index means that you — and everyone else — pay on the average 3% more for all consumer goods.) Subtracting the consumer price index rise from your bond return gives you 9.31%-3%=6.31%. Thus, 6.31% is the real return you have on your investment.

If you hold an investment for less than a year, as in a 3-month Treasury or CD, you need to adjust to make sure that you have equal time lengths for your investment and the consumer price increase. For example, if you have a 3-month CD paying 5% (annualized rate), and you learn that the consumer price index rose .5% for the 3-month period you held the investment, you must first find out how much actual interest you made on your CD during that 3-month period. Since there are four 3-month periods in the year, divide your 5% return by 4 to find how much actual interest you made during the 3 months. 5%/4=1.25%. Thus, 1.25% is the actual interest you earned during the period. Subtracting the consumer price increase of .5% during this period (1.25%-.5%=0.75%), gives you the actual return on your investment for this period.

This technique for calculating real returns works for any investment, as long as you coordinate the term period of the investment with the consumer price increase occuring during the same time period. If your investment is in a foreign currency, you need to use the consumer price increase of that particular country.

International Real Return (Forex Profit or Loss). Real return must be taken a step further when you hold an investment in the currency of a foreign country. Say you placed US$10,000 in a foreign treasury paying 10%. The consumer price index rose 6% for the year, meaning that the real return on your investment was 4% (10%-6%). But if you intend ultimately to spend your profits in U.S. dollars, you must also factor in your return or loss from foreign exchange (forex profit or loss). Forex means foreign exchange. If the currency of your investment rose 5% for the year against the dollar, your additional actual real international return was 5% of your profit, or 5% of the 4% (.05% of .04%=.2%). Adding this .2% to the 4% profit means that your total investment earnings were 4.2%. But you also made a forex profit of 5% on your US$10,000 principal. Adding that 5% to your earnings means that you actually made a total real return of 5%+4.2%=9.2% — in dollar terms. It’s interesting to note that in this instant your forex profit was more than your real return on investment. Seeing this, it should not surprise you to learn that many international companies make more each year on forex profit than they do on profit from their business activities.

“Bad Money Drives Out Good.” This oft-heard quote means that whenever a person has a choice between using a currency that has stable, underlying value (such as one backed by gold) and a currency that has no underlying value (such as a fiat currency), the person will always hoard the valuable currency and spend the worthless currency first. The truth of this epigram has been borne out whenever a country has had two systems of currency or coinage, one more stable than the other. The less stable currency is always spent first, because people realize that it will be of less value in the future. Imagine an international bank in today’s economy, holding, say, dollars and yen. When payment needs to made for something, which currency would the bank tend to use, and which would it tend to hold? Considering that the dollar has fallen to less than one- quarter of its value against the yen over the last 25 years, the bank would most certainly want to spend dollars first and hold on to the yen for the long term. Short-term considerations often arise, but inevitably people and organizations will pay for goods and services in a currency they consider to be ultimately worth less than a currency they consider to be worth more.

Hyperinflation. Extreme inflation in which prices rise uncontrollably, threatening to completely wipe out a currency’s purchasing power. The United States has never undergone hyperinflation, but many major currencies of the world have. Purchasing power of the German mark was wiped out by hyperinflation prior to WWII. Brazil, Argentina, Mexico and many other developing countries have experienced hyperinflation during the last twenty years. Today, many of the countries of the former Soviet Union are undergoing hyperinflation, with consumer price indexes rising 2,000% or more yearly.

Stagflation. A combination of economic inflation and industrial recession, during which consumer prices rise but business output falls. This is often accompanied by rising unemployment at businesses cut back. A recent example of stagflation was in the U.S. during the 1970s, when rapidly-rising oil prices pushed consumer prices up sharply but caused businesses to cut back production.

Currency Blocs. Today there are three central currency blocs, each with currencies somewhat tied to each other because of high volumes of trade and common interests. The three blocs are: North American (with the U.S. dollar as the central currency of the bloc), European (with the German mark the central currency), and the Asian-Pacific Rim (with the Japanese yen as the central currency). For maximum diversification, investment should be made in all three currency blocs because they function somewhat separately from each other. For example, the yen is not tied to the U.S. dollar as closely as, say, the Canadian dollar. Therefore, for an American investor, diversifying into the Canadian dollar would not give much protection, since it tends to rise and fall much as the U.S. dollar. For the same reason, a German investor would not find diversification safety by investing in the Swiss franc, since the currencies of these two countries tend to move in similar patterns.

Consumer Prices Rise or Fall. Consumer prices are the most immediate indication of rising or falling inflation, because they directly measure the price that consumers are paying for goods and services. The overall Consumer Price Index contains prices for a wide variety of goods, from food to oil to lumber to cars, etc. The so-called “core” Consumer Price Index is overall Consumer Price Index less the prices of oil and food, which tend to move much more rapidly than other goods and services.

Wholesale Prices. A more long-term indicator of rising or falling inflation. When Wholesale Prices move, they tend to affect consumer prices at a later date.

Financial Center. An overseas bank that offers a wide variety of financial services: checking and savings accounts, CD’s and money markets, foreign exchange, credit cards and debit cards, collateral loans and borrow low-deposit high stratetgies, international stock and bond mutual funds, international real estate funds, international foreign treasury funds, foreign treasury bonds, etc. Unlike U.S. banks, financial centers use an investor’s fundamental savings and checking accounts as the basis to fund and maintain more wide-ranging investments.

Clearing Bank. A bank that is a member of a clearing association for checks. For example, all banks in the U.S. clear through the New York clearing system. All English banks clear through the London clearing system. Thus, if an English bank sends you a check in U.S. dollars, it will normally be a check drawn by the overseas bank on its clearing bank in New York. This enables the check to clear quicker than if it had to be sent to the bank in London for collection.

Banks keep funds in accounts held at their clearing banks in foreign countries. When a bank in Switzerland, for example, receives U.S. dollars, it has no need of these dollars in Switzerland, so the funds are sent to their clearing bank in New York. Larger banks may have branches in foreign countries. They use these branches for storing of the local currency and for clearing checks written in that currency.

Private Bank. This term originally applied to banks in which the owners, who were usually partners with unlimited liability, ran the bank and pledged their entire wealth in support of the bank. These banks were normally quite small and conservative, specializing in a small sector of banking services. Today there are few truly private banks in the old sense. Instead, the term most often refers to banks that give a high degree of personal service and specialize in managing investments for private individuals. In the U.S. there are few private banks. U.S. stock brokers offer services similar to what would be expected by a European private bank.

Commercial Bank. Banks whose main business activity is taking deposits and making loans for commercial or consumer purposes. The distinction between commercial and private banking is not as clear outside the U.S., thus many large overseas banks (financial centers) run commercial banking businesses as well as offering private banking services.

Overdraft Facility. A British term for a revolving loan or collateral loan. With this facility, a limit usually is set on the amount that can be borrowed. The account holder can draw his account down to the pre- agreed amount. There is often no repayment schedule, and no interest has to be paid as long as loans and accrued interest do not exceed the agreed-upon borrowing limit. Normally the bank will hold easily- liquidated investments as collateral (stocks, bonds, mutual funds, etc.).

Forex. Forex is short for foreign exchange. When one speaks of a forex profit or loss, he is talking about the increased or decreased value of an investment caused solely by currency movements. For example, if an investor thought that the dollar was weak, he might purchase German money markets. The investor’s account might earn 3% annualized, but the real profit or loss could be in how the DM (German mark) moves against the US$ (United States dollar). If the investor held the DM money market for an entire year, and if the DM rose 5% against the dollar, the investment would, in real returns, make not only the 3% annualized interest, but 5% on the principal and 5% of the 3% interest.

Example: Say the investor put US$10,000 in DM at 3%, with the 3% held to maturity. If the DM rose 5% against the dollar during the year, when the investor was paid at maturity and exchanged his DM back into US$, he would receive, in total, his $10,000 investment — plus five percent of the $10,000 (the forex increase)– plus three percent of the interest paid on $10,000 (stated money market interest rate) — plus five percent of the three percent interest (the forex increase which would accrue even on the interest, because the interest would be paid in DM).

The investor would receive: $10,000 + .05 ($10,000) + .03 ($10,000) + .05 (.03) $10,000 = $10,815, or a profit of $815. This is a return of 8.15%. The investor would have made 3% at any rate, even if the mark had not changed against the dollar. That is, he would have made .03 ($10,000) = $300. Therefore his forex profit is $815-$300= $515, or 5.15%.

Forex Spread or Forex Cost. The difference between the buy price and sell price of exchanging one currency into another. For example, if you were converting U.S. dollars into Canadian dollars, the buy price might be 1.33 Canadian dollars per U.S. dollar. That means that it would cost you one dollar to buy 1.33 Canadian dollars. But the sell price might be 1.30 Canadian dollars per U.S. dollar. That means you would receive one U.S. dollar for every 1.30 Canadian dollars you exchanged. The difference between the buy and sell price (1.33 and 1.30 in this instance) is the forex price or forex spread of converting currencies. This cost is built into every transaction or investment that involves foreign exchange of currencies.

Swiss Franc. SFR. This is the currency of the confederation of Helvetia, commonly known as Switzerland. Hence the currency is often called CHF.

Dutch Guilder. The currency of The Netherlands. NLG stands for Netherlands Guilder. However, another name for the Guilder is the Florin (an older Duch monetary unit). The designation DFL reflects the Florin’s historical importance.

Deutsch mark. DEM or DM. (Pronounced “Doytch – mark”) The German mark, the central currency in Europe.

ECU. ECU is short for Economic Currency Unit. It is a basket of European currencies — German mark, French Franc, Dutch Guilder, Italian Lira, Belgian-Luxembourg Franc, British Pound, Spanish Peseta, Danish Kroner, Portuguese Escudo and Greek Drachma).

Spanish Peseta. ESB. Spanish in Spanish is Espanol. The code ESB reflects this Latin background.

British Pound. GBP. Called Pound Sterling or just Sterling. The currency of Great Britain, hence the code GBP. Great Britain is a nation that encompasses four states — England, Scotland, Wales and Northern Ireland. Thus Scottish and English Pounds are one and the same. They are interchangeable and are legal tender throughout Great Britain. Other Pound currencies such as the Manx Pound (issued on the Isle of Man) keep a one-to-one parity with the English and Scottish Pounds but are not legal tender except on their own island. The Irish Pound (which is correctly called the Irish Punt) used to maintain parity, but no longer does so.

Currency Allocation. This is the process of diversifying your investments into several currencies. Most currency allocation tactics first divide an investor’s savings into local and foreign currencies. For example, a U.S. investor would divide his or her porfolio into a U.S. dollar portion and a non-U.S. dollar portion, with a determined percentage for each portion. In times of a rising dollar, one normally weights the protfolio more heavily in dollars. In times of a falling dollar, one weights the portfolio out of the dollar. The second part of Currency Allocation is the choosing of other currencies and foreign investments to hold.

Consumer Price Increase. Price increases that we are paying for products and services we are buying now.

Producer Prices. Price increases wholesalers and manufacturers are paying now — causing consumer price increases in products and services later.

Wage/Earnings. Price increases in wages. Because of these, wholesalers and manufacturers will see price increases later.

In other words, Consumer Price Increases are a sign of current inflation. Producer Price Increases are an indicator of inflation that could soon be with us. And Wage/Earnings are an indicator of of inflation that could be with us at a still later date.

Velocity. The velocity of a currency measures how rapidly the currency is strengthening or weakening. This helps us measure future tendencies of strength or weakness. The velocity of a currency is measured by dividing the currency’s latest value (compared to the dollar) by the 9- month average of the currency’s value against the dollar. For instance, if the 9-month average of the yen is 97.00 (meaning that one dollar buys 97 yen), and the latest value of the yen is 101, the velocity is figured by dividing 101 by 97 (101/97=1.041). Since the yen, at 101, is higher than it had been on average during the past 9 months, the value of the yen is tending to rise, and therefore is a good bet to rise further. Velocities over 1.00 of any currency indicate that the currency may be a good buy. Velocities less than 1.00 indicate that a currency is falling in value and may be a good candidate to sell.