What gives money value, and why the US dollar rules
The answer
A banknote has value because enough other people will accept it in exchange for things you want. Two forces make that acceptance reliable: the government requires taxes to be paid in it, and it limits how much of it exists. Nothing backs it. The US dollar dominates because it is the currency most other people already accept, and that is a position that reinforces itself.
Why this costs you money
Ask 2 questions about your own money.
What currency will you spend in? If any large future payment is in a currency you do not hold — a foreign degree for your child, a medical treatment, imported equipment for your business — then you have a liability in one currency and savings in another.
What currency do you earn in? If your salary, your rent, your deposits and every company in your portfolio all produce rupees, you own 30 stocks and 1 currency.
Here is the loss, with arithmetic. Suppose you are saving in rupees for a US university degree 10 years from now. If the rupee falls against the dollar by an average of 3.5% a year over that decade, an amount worth $100,000 today will be worth about $70,000 in dollar terms when you need it, before US fee inflation. Your rupee fund grew. Its purchasing power in the currency you need shrank by roughly 30%.
Nobody warns you, because your statement is in rupees, the fees are quoted in dollars, and the 2 numbers never appear on the same page.
How it works
Why paper is worth anything
Money does 3 jobs. It is a medium of exchange, so you can sell your labour to one person and buy food from another. It is a unit of account, so prices are comparable. It is a store of value, so you can move purchasing power from today to next year. Anything that does all 3 is money — historically salt, cattle, shells, silver and gold, today paper and database entries.
Fiat money is money whose value comes from declaration rather than from material. Four things hold it up:
1. Tax demand. The government requires taxes in this currency and in no other. That alone creates permanent demand from every person and business in the country.
2. Legal tender status. A creditor must accept it in settlement of a debt. A US note says it is "legal tender for all debts, public and private". An Indian note carries the Governor's promise to pay the bearer, a survival from the era when that promise meant gold.
3. Scarcity. The issuer controls the quantity. When it stops, the money stops working, which is the subject of the previous article.
4. Acceptance by others. The largest force and the least formal. You accept rupees because you are confident the next person will.
How the world got here
The classical gold standard, roughly 1870 to 1914, fixed major currencies to a weight of gold, and exchange rates were fixed as a consequence.
Bretton Woods, 1944. The United States fixed the dollar to gold at $35 an ounce, and other countries fixed their currencies to the dollar. The dollar became the link between every currency and gold — a design decision made in a conference room.
15 August 1971. The US President announced that the United States would no longer convert dollars into gold for foreign governments. Within 2 years the major currencies were floating. Since then no major currency has been backed by anything, and the dollar's central position survived the removal of its gold backing by more than 50 years.
Why the dollar rules
Five reasons, in order of importance.
1. The Treasury market. United States government debt is the largest, most traded, most liquid market in the world. A central bank with $600 billion to store needs somewhere it can sell in size on any day, and the biggest such place is US Treasuries.
2. Network effects. Trade is invoiced in dollars because the other party expects dollars, because their bank prices in dollars, because commodity contracts are in dollars. Each user makes the next user more likely.
3. Convertibility. Dollars move into and out of the United States without permission. This is not true of most currencies, including the rupee.
4. Commodity pricing. Crude oil, most metals and most agricultural commodities are quoted in dollars worldwide.
5. No alternative of similar depth. The euro is a currency of many governments with no single bond market of comparable size. China's currency is not freely convertible. Gold does not pay interest.
The numbers
- Roughly 57% of the world's allocated foreign exchange reserves are in US dollars, with the euro around 20%.
- The dollar is on one side of roughly 89% of all foreign exchange transactions
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- Roughly 54% of global export invoicing is in dollars, far above the US share of world trade.
That third number is the interesting one. Two countries neither of which is the United States frequently settle in dollars.
What that buys the United States
The United States borrows in the currency it issues, so it can never be forced to default for lack of foreign currency. It borrows more cheaply than it otherwise would, because global demand for Treasuries is permanent. And it receives real goods for dollars that are held abroad and never spent in America. India has none of these.
What it tells you, and what it does not
Reserve status is durable, not permanent. Sterling held the position before the dollar and lost it over roughly 50 years. There was never a single day on which it changed.
Reserve status does not mean the currency always rises. The dollar has had long periods of weakness while remaining the reserve currency.
It does not mean the dollar is well managed. It means there is no alternative with the same depth. Those are different statements.
The decision rule
Match the currency of your assets to the currency of your future spending.
If you will spend rupees for the rest of your life, rupee assets are the correct default, and foreign currency exposure is a risk you are taking on purpose rather than a diversification you are owed.
If any significant future payment is in another currency — education abroad, a property, a business input you import — hold some of that fund in that currency, or in assets that rise when your own currency falls.
Owning many stocks in one country is not diversification across currencies. It is one currency exposure, held 30 times.
Try this now
Five minutes. You will finish knowing something about your own portfolio that almost no Indian investor knows about theirs.
- List everything you own with a value: bank deposits, provident fund, mutual funds, direct stocks, insurance policies with a maturity value, property. Rough numbers are fine.
- Beside each one, write the currency it will pay you in.
- Now go one level deeper on your equity holdings. For each company or fund, ask where the revenue comes from. An Indian software services company earns most of its revenue in dollars even though its share is priced in rupees. The annual report gives the split by geography. Mark each holding with the currency it earns in, not the currency it is quoted in.
- Add up: what percentage of your total assets ultimately depends on one currency?
- Separately, write down your 3 largest expected payments over the next 10 years and the currency each will be in.
What you should see. Most people find that 90% or more of their wealth depends on a single currency. That is correct for somebody whose entire life will be spent in that currency. It is a problem for anybody in step 5 who wrote down a payment in a different one.
The second surprise is in step 3. If you hold Indian information technology or pharmaceutical companies you already own dollar exposure — those companies earn dollars, and a falling rupee raises their rupee revenue. If you hold Indian oil marketing, airline or chemical companies, you own the opposite.
Three real cases
1. 15 August 1971, the United States — the backing was removed, nothing collapsed Under Bretton Woods, foreign governments could exchange dollars for US gold at $35 an ounce. By 1971 the dollars held abroad were worth far more than the gold in reserve, and President Nixon suspended convertibility. Many people expected the dollar to lose its central role once its backing was gone. More than 50 years later it holds roughly 57% of global reserves. Acceptance, not metal, was what had been holding it up.
2. The pound sterling, 1945 to 1976 — how a reserve currency loses the job Sterling was the dominant reserve and trade currency into the early 20th century. Britain emerged from the Second World War heavily indebted. Sterling was devalued in 1949 and again in 1967, and in 1976 Britain borrowed from the International Monetary Fund. Across all of this there was no single day on which sterling stopped being a reserve currency. It took roughly half a century and it was visible only afterwards.
3. India, June and July 1991 — holding a currency nobody else wants India's foreign exchange reserves fell to a level covering roughly 3 weeks of essential imports. The country had rupees. It could not buy oil with them, because oil sellers wanted dollars. In late May 1991 the government airlifted 47 tonnes of gold to the Bank of England and 20 tonnes to the Union Bank of Switzerland as collateral, raising about $600 million. The rupee was devalued in 2 steps on 1 July and 3 July 1991, by roughly 9% and then roughly 11%. A country can print its own currency without limit and still be unable to pay for a ship of crude oil. Those 2 facts are the whole lesson.
The question that resolves it
A novice asks: what backs this currency?
An expert asks: who else wants it, and what can they do with it?
Since 1971 the first question has had the same answer for every major currency: nothing. The second has completely different answers for the dollar and the rupee, and every practical consequence follows from it.
What would make this wrong
If acceptance were not the source of a currency's value, then removing gold backing would have destroyed the dollar in 1971 and adding it would rescue a failing currency today. Neither has happened. Currencies with no backing function normally for decades, and currencies collapse while their central banks still hold gold.
Three limits. Reserve status can be lost — sterling shows it takes decades, but it happens, so anybody claiming the dollar's position is permanent is claiming something history does not support. Concentration is a risk in both directions, because a large share of the world's savings sits in the obligations of one government. And none of this is a forecast. Structural position and next year's price are separate questions.
In India
The rupee is fiat money issued by the RBI under the Reserve Bank of India Act. Notes are legal tender; coins are legal tender up to specified limits.
The rupee is partially convertible. India has had full convertibility on the current account since 1994 — you may buy imports and pay for travel, education and medical treatment abroad. The capital account is controlled. Under the Liberalised Remittance Scheme, a resident individual may remit up to $250,000 per financial year for permitted purposes. Investment in and out of India operates under the Foreign Exchange Management Act.
Those controls are the direct reason the rupee is not a reserve currency. A central bank in another country cannot hold rupees as reserves if it cannot move them freely.
India has made deliberate moves to widen rupee use: rupee-denominated trade settlement with some partners, and the inclusion of Indian government bonds in global bond indices. Most Indian imports are still paid for in dollars.
In the United States
The dollar is fiat money issued by the Federal Reserve. Federal Reserve notes are legal tender for all debts.
The dollar is fully convertible and there are no capital controls on ordinary transactions. This is one of the main reasons foreign institutions hold dollars: a reserve you cannot spend is not a reserve.
The dollar's position is also a policy instrument. Because most international payments touch the US banking system, the United States can restrict a counterparty's access to dollars. No other country has a comparable tool, and its use is one of the few forces pushing others to look for alternatives.
Where they differ, and what that tells you
The difference is not size. India is among the largest economies in the world. It is convertibility and depth.
A reserve currency needs 3 things: free movement in and out, a large and liquid government bond market to hold the reserves in, and confidence that the rules will not change. India restricts the first by design, has a much smaller second, and has been improving the third. The design choice is defensible: capital controls gave India a buffer in 1997, 2008 and 2013 that fully open emerging economies did not have. The cost is that the rupee cannot become a currency others hold.
Two consequences follow, and both are concrete.
The rupee tends to fall against the dollar over long periods, roughly reflecting the inflation difference between the 2 countries. That is not a crisis. It is the normal state, and it belongs in your plan as a base case rather than as a risk.
And because India imports most of its oil in dollars, a global event that strengthens the dollar tightens Indian conditions twice — once through capital leaving, once through a higher import bill. An American investor feels one of those effects and not the other. That is why Indian markets can fall on news containing no information about India.
Carry this
- Nothing backs any major currency. Tax demand, legal tender and acceptance do the work.
- The dollar dominates because everyone else already uses it, and that is self-reinforcing.
- Match the currency of your savings to the currency of your future spending.