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The Effects of Buying Currency Bonds

Original post by Walter Johnson of Demand Media

A "currency bond" is a shorthand phrase referring to investing in foreign currencies. As of publication, the faith in the American dollar is at an all-time low. The result might well be increased interest in currencies that might be more stable, such as the Russian ruble or the Chinese Yuan. These bonds work the same as any other bond, except for the importance of exchange rate effects on the bond's worth.

Faith

When a currency is backed neither by gold, commodities or the state, such as the American dollar, the worth of the currency is based on faith. This means, in practice, that the currency is viewed as stable because the domestic market and relative global hegemony of the dollar remain powerful. When these factors no longer exist or appear weakened, then it is quite possible for the dollar to fall in value. When firms or individuals buy large amounts of other currencies as hedge investments, then faith in the dollar decreases.

Rates

Whenever foreign currencies are bought, dollars flow out of the country. The only reason one would ever buy bonds denominated in the Chinese yuan is the belief that the yuan will grow in value while the dollar will decrease. This, in turn, is based on the assumption that Chinese economic and military growth will increase, making the yuan a more significant currency over time. If Chinese bonds are bought in large-enough amounts, this will affect the American trade balance in that more dollars will be fleeing to China than is already the case. The result, at best, would be upward pressure on interest rates to compensate.

Value

The Bank of China maintains a "managed floating exchange rate system." While market forces are important in deciding on the value of the yuan, the "Managed" part of this phrase refers to the continual state role in pinning the yuan's value. The point is to use both the state and the currencies of China's major trading partners, as the value basis for the yuan. The Bank of China wants to be able to control for any sudden changes in either the dollar or the domestic Chinese economy. In countries with state-controlled currencies, such as China, buying foreign bonds in large amounts would signal the state to clamp down on such speculation. The U.S. has no such mechanism.

The Federal Reserve

In the American case, a sudden rush to buy Euros or rubles would force interest rates up and the dollar down without any mechanism to bolster the dollar. In the U.S., the Federal Reserve, independent of government, buys up large amounts of Treasury bonds to keep interest rates low. Therefore, the effect of any sudden rush to buy foreign bonds would be to force either the Fed or major trading partners such as the Canadians or Japanese to buy more American bonds. In other words, if the dollar were to begin a drastic decline, the Japanese and others would buy America bonds en masse.

                   

References

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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