In the broadest sense of the word, it was possible to ascribe an absolute value to currencies as recently as 1971. However, it was only till the Great Depression of 1929 that this valuation was at its purest.
In the pre-1929 era, the obligation of the Government, as issuer of currency, and holders of the currency was in the nature of a Trustee obligation. Governments were obligated to hold an amount equal to the value of their outstanding currency in gold and this asset could not be co-mingled with the other assets of the Government. This meant that the gold was exclusively used to back the issuance of currency, and was not available for any other governmental obligation. Not only this, but it was also obligatory for the Government to maintain a steady value for its currency vis-a-vis gold. Till this point, in corporate credit terms, the holders of a currency were secured creditors of the Government, who were assured of a value in terms of another commodity, namely gold. This is akin to a Corporate entity assuring a Bondholder who holds a Rs 100 bond, that it not only holds the Rs 100 in a separate account but promises to pay the Bondholder Rs 100 on demand. Till this point in time, the tenure of outstanding currency came to an end when a holder returned it to the Government in exchange for gold.
While asset exclusivity and the nature of the relationship was maintained after the Great Depression as well, the emergence of the Purchasing Power Parity model allowed Governments to change the value of their currencies vis-a-vis gold and, as a result, vis-a-vis other currencies as well. With this freedom in hand, almost all countries devalued their currency to gain an advantage in markets other than their own, through cheaper exports. This led to the first spree of Competitive Devaluation in the world, resulting in significant unrest. Till this point as well, countries were obligated to hold reserves in gold to underpin the value of their currency, but they were at liberty to decide this value. This meant that a currency holder was only entitled to receive its worth in terms of the currency itself, and nothing more. In corporate credit terms, this is like a Corporate entity assuring a Rs 100 bondholder, that it would hold some part of the Rs 100 in a separate account, and would not retire its obligation directly. Rather it was required that the Bondholder sell the bond in the market to retrieve its worth. There was no longer an obligation that the sum retreived would amount to Rs 100. It would be the prevailing rate for a Rs 100 bond at that time and nothing more. It was expected that the markets would assign a fair value to the currency given the quantum of reserves held and the prevailing peg of the currency to gold. From this point onwards, currency acquired immortality. It could be passed from one holder to another, but never returned to the borrower for value to be delivered.
But it was only after World War II, that the US and Allied nations got together to declare a monetary truce, which resulted in the Bretton Woods Agreement. Returning to a quasi-gold standard, most currencies were linked to the US dollar and the US dollar itself was convertible to gold at the rate of USD 35/ounce. While nations were not obligated to maintain distinct reserves anymore, they were obligated to maintain the international value of their currencies, which should have ideally resulted in adequate reserves being maintained at all times. There were strict valuation covenants specified for nations to adhere to and a change in a nation’s currency value, beyond the flexibility built into the system, required agreement from the group. While currency devaluation did happen in the time this agreement was in force, they were few and far between and due to the process, the possibility of resultant unrest was minimized. At this point, the obligation would be described as a corporate entity advising a Rs 100 Bondholder that a) The borrower was not obligated to hold any asset in a distinct account, b) Even if it held an asset, it would not be in rupees, but another currency which could be converted to Rupees, c) It would not hand over this asset to the bondholder in settlement of its claim, d) The borrower would not repay the money on demand, but d) try its best to ensure that the bond was worth Rs 100 in the market. If it wasn’t there would be no obligation to compensate the Bondholder for the loss. In effect the Bondholder now ranked equally along with all other government obligations and was just another unsecured creditor. All currencies remained perpetual in nature, with the exception of the US Dollar, which could be returned to the Federal Reserve against value delivered in gold.
If the US had stayed true to its implied promise of maintaining gold reserves, all currencies would have been backed by gold through the US Dollar and valued accordingly, even though the possibility of value leakage existed due to the absence of any firm commitment to maintaining reserves. But that didn’t happen. And on August 15 1971, the world changed. When the US unilaterally decided that the US Dollar would not be convertible to gold anymore, it effectively robbed currencies across the world the luxury of absolute value. By this time, it backed only 22 per cent of its outstanding currency in gold. But even then, it was quite simple to put a value to a nation’s currency in terms of gold through the Exchange Rate vis-a-vis the US Dollar, the US Dollar’s peg of $35/ ounce of gold and a coverage ration of 22 per cent in gold Reserves.
But from then on, all that remained from was value relative to other currencies. This doesn’t mean that currencies have no value, but after 1929 there has been a steady deterioration of the nature of the relationship between Government and the holders of a currency. This has resulted in the process of discovering a value becoming infinitely more complex. Continuing with the bondholder example, the contract would now read something like a) the company is not obligated to hold any asset to back it’s currency, b) If an asset is held, it would be a part of the General Account and be available to all obligations, c) There is no predefined value to the company’s obligation to the bondholder, d) in the absence of this predefined value, obligation having a pre-defined value would outrank this obligation and be settled against assets first which means e) whatever is left after settling all other obligations would be divided amongst the currency holders in the ratio of the currency held and this would amount to a full and final settlement of all obligations of the company towards the Bondholder. And of course, the bond could not be returned to the company till such time the company was in existence.
One would be excused for thinking that this does not sound like a loan or credit obligation. It isn’t. It is now an quasi-equity obligation against the balance sheet of the issuing Government. The change in the nature of the obligation through the years has disadvantaged currency holders from the risk perspective without any form of discussion with them and consent from them. And if this wasn’t bad enough, there is no way for a currency holder to find even a rough estimate of the value of his currency as Governments do not maintain, or publish a Balance Sheet*.
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To describe what a Government’s Balance Sheet would look like, one would have to use corporate analogy. For even more relevance, let us try to imagibne what the Balance Sheet of the Government of India would look like.
On the asset side of a Government balance sheet are all the assets owned by the Government. As in the case of a corporate entity, these would be divided into Movable & Immovable property, Investments, Cash & Bank Balances and most importantly, Accumulated Losses (or Accumulated Deficit) .
On the liabilities side would be the Debt and Equity Obligations of the Government. Debt would comprise of all outstanding Market debt, Small Savings Obligations, Loans taken (Domestic & Foreign) etc. The balancing figure, Net Assets (Total assets(Excluding Accumulated losses) minus Debt) would be the value of Equity, or the value of currency issued. When divided by the quantity of currency, a per unit value would also be available.
Even if all assets were to be valued in rupee terms, there is a distinct possibility that this value would not be equal to the face value of the currency in existence. This is because of the presence of Accumulated Deficits through the years. It is also possible that the Net Assets, as described above, would be a negative number. Which would essentially mean that the currency that we hold is worthless, or worth just the paper it’s printed on.
No matter how it turns out, currency holders have a right to know what their currency is worth. Its a right they have been denied for over 40 years now.
Along with Right to Education and Right to Food, this is an idea whose time has come.
The author is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He blogs at www.rajivshastri.com