At its heart the question ‘What makes a trading currency” is a political question.
Currencies are governmental creations, or, like the euro, a cooperative enterprise of several national governments. A ‘hard’, ‘trading’, ‘floating’ or ‘convertible’ currency, the terms are used interchangeably, is one whose value is set by the international currency markets not by the sponsoring entity.
In a ‘hard’ or ‘convertible’ currency a private investor or company may conclude a currency trade at any time at a rate provided by another private company. The ‘currency trade’ is an agreement between those two parties and does not reference a rate set by a third party.
A’ non-trading’ or ‘non-convertible’ currency is one where the exchange rate of a private sector currency trade is set by a national government.
There are several ways that a national government may control the convertibility of its currency, but the primary one is based on trade flow. Even though over 90% of the daily turnover in the FX markets is speculative, that is no actual currency is exchanged, the remaining portion must be settled or exchanged through the international banking system. Because banks are regulated by national governments, a government may, if it chooses, set the rate at which it will permit a bank to exchange an outside currency for its national currency.
For example, if a European manufacturer, after selling goods in the United States, wished to return profits to Europe it could ask any bank for a price in euro. The bank would say 1.3350-53 (the market at writing). The manufacturer would then sell its dollars to the bank at 1.3350 and receive the equivalent amount in euro in its account.
Since the trade is voluntary neither side would agree to do the deal unless the rate was satisfactory to both parties. If the bank tried to set the rate too low, that is to provide too few euros for the amount of dollars, the company would refuse to do the deal and vice versa. The rate is easy to set because each party has access to the international foreign exchange market, which records the most recent rates for similar deals.
For a non-convertible currency there is no external reference rate upon which two private parties can base a deal. All trade flows are exchanged with national banks at rates determined by the national government.
There is no international currency market upon which to base exchange rates; there is no way to exchange funds without using the national banking system of the ‘non-convertible’ country. No bank, within China or outside China, will conclude an exchange trade at a rate outside the band set by the Chinese government. If an American manufacturer wishes to return profits earned in China, it can only conduct the trade at a rate provided by a bank but set by the Chinese government.
The government of a floating currency will attempt to influence the exchange rate of its currency against other currencies. It may intervene directly in the currency markets by buying or selling its own currency. It might change its domestic interest rate or simply by try to talk its currency higher or lower as the Japanese have recently very successfully done.
But because the volume of the currency market is so much greater than the monetary resources that any government can bring to bear, all attempts to influence the currency markets are at best short term unless backed by substantive developments in interest rate or other fiscal and monetary policies. Eventually the currency market will seek the level that its participants determine is warranted by the economic and financial facts.
Even a central bank’s freedom to change its domestic interest rate purely on exchange rate considerations is severely limited by the considerations of its domestic economy. If a central bank, in order to increase the exchange value of its currency, wanted to raise domestic interest rates, it would risk damaging the growth rate of its own economy. In reality national economic and political factors almost always trump exchange rate factors.
The degree of ‘convertibility, or ‘float’, of national currencies is a continuum based on the amount of influence that a national government exercises over the exchange rate.
At the free end of the spectrum, where governments have the least direct control of the exchange rate are the US Dollar, the Euro, the British Sterling, the Swiss Franc , the Japanese Yen, the Canadian Dollar and other currencies whose currency tools are all indirect.
In the middle range are currencies like the Singaporean Dollar, where the rate is not ‘set’ by the government, but is heavily influenced by its wishes. At the ‘non-convertible’ end of the spectrum are the Chinese Yuan, the Cuban Peso, and others where the exchange rate is determined, within narrow parameters, by the national government.
Chief Market Strategist