What Is A Currency Union?
A currency union is a group of countries, municipalities, or regions that share a monetary standard. Typically, currency unions feature either common banknotes and coinage or a peg to an external monetary unit. By taking such measures, members are able to promote pricing stability and actively manage exchange rate volatilities within the context of a defined framework.
Also referred to as monetary unions, currency unions furnish participants with several distinct advantages and disadvantages:
Advantages: Currency union members enjoy reduced transaction costs and foreign exchange risk pertaining to both commerce and travel. Also, interest rates for participants become aligned, which works to stabilise borrowing and lending functions.
Disadvantages: Union members lose autonomy in regards to domestic monetary policy. If faced with unique inflationary or deflationary pressures, a union member is unable to act unilaterally to mitigate negative impacts.
While constituents of a currency union share a monetary standard, the allegiance falls short of a comprehensive economic union. Concessions pertaining to trade and commerce are not made, which preserves the cohesion of the local economy.
History Of Currency Unions
Currency unions have a long and storied history of bringing relative stability to fragmented nations or geographic regions. From war-torn areas to emerging economies, nations often seek membership to monetary unions in an attempt to restore economic order.
An early example of a currency union was the German Zollverein of the 19th century. The Zollverein was initiated in North Germany in 1818, with only specific coinage being universally recognised. Over time, the union expanded to include members from around the Germanic region. In the years following the end of the Franco-Prussian war in 1871, the Reichsmark became the common currency among Germany's member states.
Another case of a currency union developing was the Latin Monetary Union of 1865. The Latin union was a bimetallic system based upon the scalable trade of gold and silver. Participants included France, Italy, Belgium and Switzerland. The Latin union was short-lived, disbanding in 1867 when delegates from member nations voted to shift to an exclusively gold-based system.
Although not a formal currency union, the Bretton Woods Accords standardised the global monetary system. During the aftermath of post-WWII, Bretton Woods effectively placed the world on a currency peg to the United States dollar (USD). Through forming the World Bank Group (WBG) and International Monetary Fund (IMF), Bretton Woods promoted a system of currency convertibility. International transactions were denominated in U.S. dollars, with the USD's value fixed to gold at US$35 per ounce. Forty-four nations signed on to the Bretton Woods system, with the agreement ceasing in 1971 with the United States' abandonment of the gold standard.
Modern Examples Of Currency Unions
As of this writing (December 2019), there are several prominent examples of currency unions in operation. Most notably is the adoption of the euro (EUR) by 19 of 28 European Union (EU) countries. Also, the British pound sterling (GBP) is used abroad in the Pitcairn Islands, South Georgia and the South Sandwich Islands. The GBP serves as a peg for many currencies such as the Gibraltar pound, Falklands pound and Guernsey pound.
In addition to the EUR and GBP, several nations use the USD as a domestic currency or peg. Egypt, Hong Kong and Saudi Arabia are a few independent countries that prefer to limit exchange rate volatilities to those experienced by the USD. Puerto Rico, Ecuador, El Salvador, American Samoa and Guam are a few areas that implement the USD as their premier form of money.
This article was last updated on 8th January 2020.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…