Composite Currency

A composite currency is a weighted combination or basket of two or more currencies. A composite currency ordinarily would not circulate as a medium of exchange, as does the U.S. dollar or Japanese yen, but it can serve as a unit of account and store of value. Service as medium of exchange, store of value, and unit of account are the three basic functions of money.

The European Currency Unit (ECU) was the most successful composite currency until it was officially formalized as one currency in the form of the euro. According to the weight given each currency on September 1989, the Deutsche mark accounted for roughly 30 percent of the value of the ECU, the French franc accounted for about 19 percent, the British pound sterling about 13 percent, and the Italian lira for about 10 percent (Journal of Accountancy, 1994). The Dutch guilder, Belgian franc, Spanish peseta, Danish krona, Irish punt, Greek drachma, Portuguese escudo, and Luxembourg franc accounted for the remaining value of the ECU at various fixed percentages. The percentages contributed by each currency equaled 100 percent. Before the introduction of the euro, European banks accepted deposits in ECU, made loans in ECU, and European corporations issued bonds in ECU. Private acceptance of the ECU paved the way for the euro.

The Special Drawing Rights (SDRs) created by the International Monetary Fund represents another example of a composite currency. At first, 16 major currencies defined the value of SDRs. In 1981 the International Monetary Fund reduced the number of currencies to five, the U.S. dollar, the Deutsche mark, the French franc, the yen, and the pound sterling. After the introduction of the euro, the number of currencies fell to four, the U.S. dollar, the yen, the euro, and the pound sterling. Some observers saw the makings of an ideal international currency in SDRs. The private sector gave lukewarm reception to SDRs. At one time, the Bank for International Settlements reported 13 bond issues worldwide that were denominated in private SDRs.

From the viewpoint of foreign investors, composite currencies provide a means of diversifying currency risk. If one currency in the basket loses value relative to the dollar or the investor’s base currency, the damage is limited to the currency’s share in the basket. A disadvantage of composite currencies arises because the weights that make up a composite currency are usually set by an official agency. Private sector use of composite currencies require complicated contracts explaining what happens if the official weights change before a bond matures or long-term contract expires.

Composite currencies provide one solution to a problem in comparing the performance of global corporations. Assume two global corporations, one headquartered in the United States, and the other headquartered in Switzerland. Further, assume that these two companies have identical asset holdings worldwide. One of these companies could report a gain and the other company a loss if the currency of one country strengthened and the currency of the other country weakened. This discrepancy in earnings would occur even if the performance of the two companies was roughly even.

The success of the ECU has led to suggestions that East Asian countries should establish a composite currency based on a basket of regional currencies. Proponents argue that a composite currency based on a weighted basket of East Asian currencies would be less vulnerable to speculative attacks. In the East Asian Crisis of 1997, speculative attacks on one currency led to speculative attacks on other currencies.