Islamic Foreign Exchange

Trading one currency for another is, in principle, permissible in Islamic law. Trading currency on a forward basis is not permissible.

Contemporary forex trading also involves a lot of speculation and volatility. Therefore scholars differ on whether this is permissible or not, much like day trading in stocks.

For an in-depth analysis, we will refer to the extensive Islamic Forex Trading article by Dr. Mohammed Obaidullah.

Dr Mohammed Obaidullah is an Associate Professor at the Islamic Economics Research Center, King Abdulaziz University, Jeddah, Saudi Arabia. His recent assignments include an Associate Professorship at the International Islamic University Malaysia and the Xavier Institute of Management, India. His areas of interest include: Islamic Finance, Security Markets, and Development Finance.

Dr Obaidullah is the Editor of the International Journal of Islamic Financial Services and IBF Review. He is the Founder Director of IBF Net: The Islamic Business and Finance Network, the Netversity and the International Institute of Islamic Business and Finance (IIIBF), India. He currently serves the International Association for Islamic Economics (IAIE) as its Secretary General.

• Islamic Financial Services, Scientific Publishing Centre, King Abdulaziz University, Jeddah, 2005
  
• Islamic Financial Markets, Institute of Objective Studies, New Delhi, 2004
  
• Rating of Islamic Financial Institutions, Scientific Publishing Centre, King Abdulaziz University, Jeddah, 2005
  
• Teaching Corporate Finance from an Islamic Perspective, Scientific Publishing Centre, King Abdulaziz University, Jeddah (forthcoming)

Recent Papers in Refereed Journals & Conferences

• Zakah on Equity Stocks, Journal of King Abdulaziz University (Islamic Economics), 2004
  
• Capital Adequacy Norms for Islamic Financial Institutions, Islamic Economic Studies, IRTI, IDB
  
• Financial Engineering with Islamic Options, Islamic Economic Studies, IRTI, IDB
  
• Contracting in Currency Markets, Journal of King Abdulaziz University (Islamic Economics)
  
• Strategies in Islamic Funds Industry, Proceedings of the Fifth Harvard University Forum on Islamic Finance, 2002
  
• Regulation of Stock Market in an Islamic Economy, Proceedings of the Fourth International Conference on Islamic Economics, Loughborough University, 2000
  
• Designing Islamic Contracts for Islamic Project Finance, Proceedings of the Third Harvard University Forum on Islamic Finance, 1999
  
• Islamic Risk Management, Proceedings of the 10th Islamic Banking Seminar organized by Iran Banking Institute, Central Bank of Iran in Tehran, 1999

Dr Obaidullah is also the author of "Indian Stock Markets: Theories and Evidence" published by the Institute of Chartered Financial Analysts of India, Hyderabad. His research papers have been published in a wide range of refereed journals as the Islamic Economic Studies (Islamic Research and Training Institute, IDB, Jeddah, Journal of the King Abdulaziz University (Islamic Economics), Jeddah, Journal of Objective Studies, Security Analysts Journal (Security Analysts Association of Japan), Securities Industries Review (Singapore Securities Research Institute), Vikalpa, Decision, iimb Management Review, Chartered Accountant, Chartered Financial Analyst, Finance India, Indian Journal of Quantitative Economics, and Indian Management.

The Basic Exchange Contracts

There is a general consensus among Islamic jurists on the view that currencies of different countries can be exchanged on a spot basis at a rate different from unity, since currencies of different countries are distinct entities with different values or intrinsic worth, and purchasing power. There also seems to be a general agreement among a majority of scholars on the view that currency exchange on a forward basis is not permissible, that is, when the rights and obligations of both parties relate to a future date. However, there is considerable difference of opinion among jurists when the rights of either one of the parties, which is same as obligation of the counterparty, is deferred to a future date.

To elaborate, let us consider the example of two individuals A and B who belong to two different countries, India and US respectively. A intends to sell Indian rupees and buy U.S dollars. The converse is true for B. The rupee-dollar exchange rate agreed upon is 1:20 and the transaction involves buying and selling of $50. The first situation is that A makes a spot payment of Rs1000 to B and accepts payment of $50 from B. The transaction is settled on a spot basis from both ends. Such transactions are valid and Islamically permissible. There are no two opinions about the same. The second possibility is that settlement of the transaction from both ends is deferred to a future date, say after six months from now. This implies that both A and B would make and accept payment of Rs1000 or $50, as the case may be, after six months. The predominant view is that such a contract is not Islamically permissible. A minority view considers it permissible. The third scenario is that the transaction is partly settled from one end only. For example, A makes a payment of Rs1000 now to B in lieu of a promise by B to pay $50 to him after six months. Alternatively, A accepts $50 now from B and promises to pay Rs1000 to him after six months. There are diametrically opposite views on the permissibility of such contracts which amount to bai-salam in currencies. The purpose of this paper is to present a comprehensive analysis of various arguments in support and against the permissibility of these basic contracts involving currencies. The first form of contracting involving exchange of countervalues on a spot basis is beyond any kind of controversy. Permissibility or otherwise of the second type of contract in which delivery of one of the countervalues is deferred to a future date, is generally discussed in the framework of riba prohibition. Accordingly we discuss this contract in detail in section 2 dealing with the issue of prohibition of riba. Permissibility of the third form of contract in which delivery of both the countervalues is deferred, is generally discussed within the framework of reducing risk and uncertainty or gharar involved in such contracts. This, therefore, is the central theme of section 3 which deals with the issue of gharar. Section 4 attempts a holistic view of the Sharia relates issues as also the economic significance of the basic forms of contracting in the currency market.

The Issue of Riba Prohibition

The divergence of views¹ on the permissibility or otherwise of exchange contracts in currencies can be traced primarily to the issue of riba prohibition.

The need to eliminate riba in all forms of exchange contracts is of utmost importance. Riba in its Sharia context is generally defined² as an unlawful gain derived from the quantitative inequality of the countervalues in any transaction purporting to effect the exchange of two or more species (anwa), which belong to the same genus (jins) and are governed by the same efficient cause (illa). Riba is generally classified into riba al-fadl (excess) and riba al-nasia (deferment) which denote an unlawful advantage by way of excess or deferment respectively. Prohibition of the former is achieved by a stipulation that the rate of exchange between the objects is unity and no gain is permissible to either party. The latter kind of riba is prohibited by disallowing deferred settlement and ensuring that the transaction is settled on the spot by both the parties. Another form of riba is called riba al-jahiliyya or pre-Islamic riba which surfaces when the lender asks the borrower on the maturity date if the latter would settle the debt or increase the same. Increase is accompanied by charging interest on the amount initially borrowed.

The prohibition of riba in the exchange of currencies belonging to different countries requires a process of analogy (qiyas). And in any such exercise involving analogy (qiyas), efficient cause (illa) plays an extremely important role. It is a common efficient cause (illa), which connects the object of the analogy with its subject, in the exercise of analogical reasoning. The appropriate efficient cause (illa) in case of exchange contracts has been variously defined by the major schools of Fiqh. This difference is reflected in the analogous reasoning for paper currencies belonging to different countries.

A question of considerable significance in the process of analogous reasoning relates to the comparison between paper currencies with gold and silver. In the early days of Islam, gold and silver performed all the functions of money (thaman). Currencies were made of gold and silver with a known intrinsic value (quantum of gold or silver contained in them). Such currencies are described as thaman haqiqi, or naqdain in Fiqh literature. These were universally acceptable as principal means of exchange, accounting for a large chunk of transactions. Many other commodities, such as, various inferior metals also served as means of exchange, but with limited acceptability. These are described as fals in Fiqh literature. These are also known as thaman istalahi because of the fact that their acceptability stems not from their intrinsic worth, but due to the status accorded by the society during a particular period of time. The above two forms of currencies have been treated very differently by early Islamic jurists from the standpoint of permissibility of contracts involving them. The issue that needs to be resolved is whether the present age paper currencies fall under the former category or the latter. One view is that these should be treated at par with thaman haqiqi or gold and silver, since these serve as the principal means of exchange and unit of account like the latter. Hence, by analogous reasoning, all the Sharia-related norms and injunctions applicable to thaman haqiqi should also be applicable to paper currency. Exchange of thaman haqiqi is known as bai-sarf, and hence, the transactions in paper currencies should be governed by the Sharia rules relevant for bai-sarf. The contrary view asserts that paper currencies should be treated in a manner similar to fals or thaman istalahi because of the fact that their face value is different from their intrinsic worth. Their acceptability stems from their legal status within the domestic country or global economic importance (as in case of US dollars, for instance).

A Synthesis of Alternative Views

Analogical reasoning (qiyas) for riba prohibition

The prohibition of riba is based on the tradition that the holy prophet (peace be upon him) said, "Sell gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot." Thus, the prohibition of riba applies primarily to the two precious metals (gold and silver) and four other commodities (wheat, barley, dates and salt). It also applies, by analogy (qiyas) to all species which are governed by the same efficient cause (illa) or which belong to any one of the genera of the six objects cited in the tradition. However, there is no general agreement among the various schools of Fiqh and even scholars belonging to the same school on the definition and identification of efficient cause (illa) of riba.

For the Hanafis, efficient cause (illa) of riba has two dimensions: the exchanged articles belong to the same genus (jins); these possess weight (wazan) or measurability (kiliyya). If in a given exchange, both the elements of efficient cause (illa) are present, that is, the exchanged countervalues belong to the same genus (jins) and are all weighable or all measurable, then no gain is permissible (the exchange rate must be equal to unity) and the exchange must be on a spot basis. In case of gold and silver, the two elements of efficient cause (illa) are: unity of genus (jins) and weighability. This is also the Hanbali view according to one version³. (A different version is similar to the Shafii and Maliki view, as discussed below.) Thus, when gold is exchanged for gold, or silver is exchanged for silver, only spot transactions without any gain are permissible. It is also possible that in a given exchange, one of the two elements of efficient cause (illa) is present and the other is absent. For example, if the exchanged articles are all weighable or measurable but belong to different genus (jins) or, if the exchanged articles belong to same genus (jins) but neither is weighable nor measurable, then exchange with gain (at a rate different from unity) is permissible, but the exchange must be on a spot basis. Thus, when gold is exchanged for silver, the rate can be different from unity but no deferred settlement is permissible. If none of the two elements of efficient cause (illa) of riba are present in a given exchange, then none of the injunctions for riba prohibition apply. Exchange can take place with or without gain and both on a spot or deferred basis.

Considering the case of exchange involving paper currencies belonging to different countries, riba prohibition would require a search for efficient cause (illa). Currencies belonging to different countries are clearly distinct entities; these are legal tender within specific geographical boundaries with different intrinsic worth or purchasing power. Hence, a large majority of scholars perhaps rightly assert that there is no unity of genus (jins). Additionally, these are neither weighable nor measurable. This leads to a direct conclusion that none of the two elements of efficient cause (illa) of riba exist in such exchange. Hence, the exchange can take place free from any injunction regarding the rate of exchange and the manner of settlement. The logic underlying this position is not difficult to comprehend. The intrinsic worth of paper currencies belonging to different countries differ as these have different purchasing power. Additionally, the intrinsic value or worth of paper currencies cannot be identified or assessed unlike gold and silver which can be weighed. Hence, neither the presence of riba al-fadl (by excess), nor riba al-nasia (by deferment) can be established.

The Shafii school of Fiqh considers the efficient cause (illa) in case of gold and silver to be their property of being currency (thamaniyya) or the medium of exchange, unit of account and store of value . This is also the Maliki view. According to one version of this view, even if paper or leather is made the medium of exchange and is given the status of currency, then all the rules pertaining to naqdain, or gold and silver apply to them. Thus, according to this version, exchange involving currencies of different countries at a rate different from unity is permissible, but must be settled on a spot basis. Another version of the above two schools of thought is that the above cited efficient cause (illa) of being currency (thamaniyya) is specific to gold and silver, and cannot be generalized. That is, any other object, if used as a medium of exchange, cannot be included in their category. Hence, according to this version, the Sharia injunctions for riba prohibition are not applicable to paper currencies. Currencies belonging to different countries can be exchanged with or without gain and both on a spot or deferred basis.

Proponents of the earlier version cite the case of exchange of paper currencies belonging to the same country in defense of their version. The consensus opinion of jurists in this case is that such exchange must be without any gain or at a rate equal to unity and must be settled on a spot basis. What is the rationale underlying the above decision? If one considers the Hanafi and the first version of Hanbali position then, in this case, only one dimension of the efficient cause (illa) is present, that is, they belong to the same genus (jins). But paper currencies are neither weighable nor measurable. Hence, Hanafi law would apparently permit exchange of different quantities of the same currency on a spot basis. Similarly if the efficient cause of being currency (thamaniyya) is specific only to gold and silver, then Shafii and Maliki law would also permit the same. Needless to say, this amounts to permitting riba-based borrowing and lending. This shows that, it is the first version of the Shafii and Maliki thought which underlies the consensus decision of prohibition of gain and deferred settlement in case of exchange of currencies belonging to the same country. According to the proponents, extending this logic to exchange of currencies of different countries would imply that exchange with gain or at a rate different from unity is permissible (since there no unity of jins), but settlement must be on a spot basis.

Comparison between currency exchange and bai-sarf

Bai-sarf is defined in Fiqh literature as an exchange involving thaman haqiqi, defined as gold and silver, which served as the principal medium of exchange for almost all major transactions.

Proponents of the view that any exchange of currencies of different countries is same as bai-sarf argue that in the present age paper currencies have effectively and completely replaced gold and silver as the medium of exchange. Hence, by analogy, exchange involving such currencies should be governed by the same Sharia rules and injunctions as bai-sarf. It is also argued that if deferred settlement by either parties to the contract is permitted, this would open the possibilities of riba-al nasia.

Opponents of categorization of currency exchange with bai-sarf however point out that the exchange of all forms of currency (thaman) cannot be termed as bai-sarf. According to this view bai-sarf implies exchange of currencies made of gold and silver (thaman haqiqi or naqdain) alone and not of money pronounced as such by the state authorities (thaman istalahi). The present age currencies are examples of the latter kind. These scholars find support in those writings which assert that if the commodities of exchange are not gold or silver, (even if one of these is gold or silver) then, the exchange cannot be termed as bai-sarf. Nor would the stipulations regarding bai-sarf be applicable to such exchanges. According to Imam Sarakhsi⁴ "when an individual purchases fals or coins made out of inferior metals, such as, copper (thaman istalahi) for dirhams (thaman haqiqi) and makes a spot payment of the latter, but the seller does not have fals at that moment, then such exchange is permissible... taking possession of commodities exchanged by both parties is not a precondition" (while in case of bai-sarf, it is.) A number of similar references exist which indicate that jurists do not classify an exchange of fals (thaman istalahi) for another fals (thaman istalahi) or gold or silver (thaman haqiqi), as bai-sarf.

Hence, the exchanges of currencies of two different countries which can only qualify as thaman istalahi can not be categorized as bai-sarf. Nor can the constraint regarding spot settlement be imposed on such transactions. It should be noted here that the definition of bai-sarf is provided Fiqh literature and there is no mention of the same in the holy traditions. The traditions mention about riba, and the sale and purchase of gold and silver (naqdain) which may be a major source of riba, is described as bai-sarf by the Islamic jurists. It should also be noted that in Fiqh literature, bai-sarf implies exchange of gold or silver only; whether these are currently being used as medium of exchange or not. Exchange involving dinars and gold ornaments, both quality as bai-sarf. Various jurists have sought to clarify this point and have defined sarf as that exchange in which both the commodities exchanged are in the nature of thaman, not necessarily thaman themselves. Hence, even when one of the commodities is processed gold (say, ornaments), such exchange is called bai-sarf.

Proponents of the view that currency exchange should be treated in a manner similar to bai-sarf also derive support from writings of eminent Islamic jurists. According to Imam Ibn Taimiya "anything that performs the functions of medium of exchange, unit of account, and store of value is called thaman, (not necessarily limited to gold & silver). Similar references are available in the writings of Imam Ghazzali⁵ As far as the views of Imam Sarakhshi is concerned regarding exchange involving fals, according to them, some additional points need to be taken note of. In the early days of Islam, dinars and dirhams made of gold and silver were mostly used as medium of exchange in all major transactions. Only the minor ones were settled with fals. In other words, fals did not possess the characteristics of money or thamaniyya in full and was hardly used as store of value or unit of account and was more in the nature of commodity. Hence there was no restriction on purchase of the same for gold and silver on a deferred basis. The present day currencies have all the features of thaman and are meant to be thaman only. The exchange involving currencies of different countries is same as bai-sarf with difference of jins and hence, deferred settlement would lead to riba al-nasia.

Dr Mohamed Nejatullah Siddiqui illustrates this possibility with an example⁶. He writes "In a given moment in time when the market rate of exchange between dollar and rupee is 1:20, if an individual purchases $50 at the rate of 1:22 (settlement of his obligation in rupees deferred to a future date), then it is highly probable that he is , in fact, borrowing Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later date. (Since, he can obtain Rs 1000 now, exchanging the $50 purchased on credit at spot rate)" Thus, sarf can be converted into interest-based borrowing & lending.

Defining thamaniyya is the key?

It appears from the above synthesis of alternative views that the key issue seems to be a correct definition of thamaniyya. For instance, a fundamental question that leads to divergent positions on permissibility relates to whether thamaniyya is specific to gold and silver, or can be associated with anything that performs the functions of money. We raise some issues below which may be taken into account in any exercise in reconsideration of alternative positions.

It should be appreciated that thamaniyya may not be absolute and may vary in degrees. It is true that paper currencies have completely replaced gold and silver as medium of exchange, unit of account and store of value. In this sense, paper currencies can be said to possess thamaniyya. However, this is true for domestic currencies only and may not be true for foreign currencies. In other words, Indian rupees possess thamaniyya within the geographical boundaries of India only, and do not have any acceptability in US. These cannot be said to possess thamaniyya in US unless a US citizen can use Indian rupees as a medium of exchange, or unit of account, or store of value. In most cases such a possibility is remote. This possibility is also a function of the exchange rate mechanism in place, such as, convertibility of Indian rupees into US dollars, and whether a fixed or floating exchange rate system is in place. For example, assuming free convertibility of Indian rupees into US dollars and vice versa, and a fixed exchange rate system in which the rupee-dollar exchange rate is not expected to increase or decrease in the foreseeable future, thamaniyya of rupee in US is considerably improved. The example cited by Dr Nejatullah Siddiqui also appears quite robust under the circumstances. Permission to exchange rupees for dollars on a deferred basis (from one end, of course) at a rate different from the spot rate (official rate which is likely to remain fixed till the date of settlement) would be a clear case of interest-based borrowing and lending. However, if the assumption of fixed exchange rate is relaxed and the present system of fluctuating and volatile exchange rates is assumed to be the case, then it can be shown that the case of riba al-nasia breaks down. We rewrite his example: "In a given moment in time when the market rate of exchange between dollar and rupee is 1:20, if an individual purchases $50 at the rate of 1:22 (settlement of his obligation in rupees deferred to a future date), then it is highly probable that he is , in fact, borrowing Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later date. (Since, he can obtain Rs 1000 now, exchanging the $50 purchased on credit at spot rate)" This would be so, only if the currency risk is non-existent (exchange rate remains at 1:20), or is borne by the seller of dollars (buyer repays in rupees and not in dollars). If the former is true, then the seller of the dollars (lender) receives a predetermined return of ten percent when he converts Rs1100 received on the maturity date into $55 (at an exchange rate of 1:20). However, if the latter is true, then the return to the seller (or the lender) is not predetermined. It need not even be positive. For example, if the rupee-dollar exchange rate increases to 1:25, then the seller of dollar would receive only $44 (Rs 1100 converted into dollars) for his investment of $50.

Here two points are worth noting. First, when one assumes a fixed exchange rate regime, the distinction between currencies of different countries gets diluted. The situation becomes similar to exchanging pounds with sterlings (currencies belonging to the same country) at a fixed rate. Second, when one assumes a volatile exchange rate system, then just as one can visualize lending through the foreign currency market (mechanism suggested in the above example), one can also visualize lending through any other organized market (such as, for commodities or stocks.) If one replaces dollars for stocks in the above example, it would read as: "In a given moment in time when the market price of stock X is Rs 20, if an individual purchases 50 stocks at the rate of Rs 22 (settlement of his obligation in rupees deferred to a future date), then it is highly probable that he is , in fact, borrowing Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later date. (Since, he can obtain Rs 1000 now, exchanging the 50 stocks purchased on credit at current price)" In this case too as in the earlier example, returns to the seller of stocks may be negative if stock price rises to Rs 25 on the settlement date. Hence, just as returns in the stock market or commodity market are Islamically acceptable because of the price risk, so are returns in the currency market because of fluctuations in the prices of currencies.

A unique feature of thaman haqiqi or gold and silver is that the intrinsic worth of the currency is equal to its face value. Thus, the question of different geographical boundaries within which a given currency, such as, dinar or dirham circulates, is completely irrelevant. Gold is gold whether in country A or country B. Thus, when currency of country A made of gold is exchanged for currency of country B, also made of gold, then any deviation of the exchange rate from unity or deferment of settlement by either party cannot be permitted as it would clearly involve riba al-fadl and also riba al-nasia. However, when paper currencies of country A is exchanged for paper currency of country B, the case may be entirely different. The price risk (exchange rate risk), if positive, would eliminate any possibility of riba al-nasia in the exchange with deferred settlement. However, if price risk (exchange rate risk) is zero, then such exchange could be a source of riba al-nasia if deferred settlement is permitted⁷.

Another point that merits serious consideration is the possibility that certain currencies may possess thamaniyya, that is, used as a medium of exchange, unit of account, or store of value globally, within the domestic as well as foreign countries. For instance, US dollar is legal tender within US; it is also acceptable as a medium of exchange or unit of account for a large volume of transactions across the globe. Thus, this specific currency may be said to possesses thamaniyya globally, in which case, jurists may impose the relevant injunctions on exchanges involving this specific currency to prevent riba al-nasia. The fact is that when a currency possesses thamaniyya globally, then economic units using this global currency as the medium of exchange, unit of account or store of value may not be concerned about risk arising from volatility of inter-country exchange rates. At the same time, it should be recognized that a large majority of currencies do not perform the functions of money except within their national boundaries where these are legal tender.

Riba and risk cannot coexist in the same contract. The former connotes a possibility of returns with zero risk and cannot be earned through a market with positive price risk. As has been discussed above, the possibility of riba al-fadl or riba al-nasia may arise in exchange when gold or silver function as thaman; or when the exchange involves paper currencies belonging to the same country; or when the exchange involves currencies of different countries following a fixed exchange rate system. The last possibility is perhaps unIslamic⁸ since price or exchange rate of currencies should be allowed to fluctuate freely in line with changes in demand and supply and also because prices should reflect the intrinsic worth or purchasing power of currencies. The foreign currency markets of today are characterised by volatile exchange rates. The gains or losses made on any transaction in currencies of different countries, are justified by the risk borne by the parties to the contract.

Possibility of riba with futures and forwards

So far, we have discussed views on the permissibility of bai salam in currencies, that is, when the obligation of only one of the parties to the exchange is deferred. What are the views of scholars on deferment of obligations of both parties? Typical example of such contracts are forwards and futures⁹. According to a large majority of scholars, this is not permissible on various grounds, the most important being the element of risk and uncertainty (gharar) and the possibility of speculation of a kind which is not permissible. This is discussed in section 3. However, another ground for rejecting such contracts may be riba prohibition. In the preceding paragraph we have discussed that bai salam in currencies with fluctuating exchange rates can not be used to earn riba because of the presence of currency risk. It is possible to demonstrate that currency risk can be hedged or reduced to zero with another forward contract transacted simultaneously. And once risk is eliminated, the gain clearly would be riba.

We modify and rewrite the same example: "In a given moment in time when the market rate of exchange between dollar and rupee is 1:20, an individual purchases $50 at the rate of 1:22 (settlement of his obligation in rupees deferred to a future date), and the seller of dollars also hedges his position by entering into a forward contract to sell Rs1100 to be received on the future date at a rate of 1:20, then it is highly probable that he is , in fact, borrowing Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later date. (Since, he can obtain Rs 1000 now, exchanging the 50 dollars purchased on credit at spot rate)" The seller of the dollars (lender) receives a predetermined return of ten percent when he converts Rs1100 received on the maturity date into 55 dollars (at an exchange rate of 1:20) for his investment of 50 dollars irrespective of the market rate of exchange prevailing on the date of maturity.

Another simple possible way to earn riba may even involve a spot transaction and a simultaneous forward transaction. For example, the individual in the above example purchases $50 on a spot basis at the rate of 1:20 and simultaneously enters into a forward contract with the same party to sell $50 at the rate of 1:21 after one month. In effect this implies that he is lending Rs1000 now to the seller of dollars for one month and earns an interest of Rs50 (he receives Rs1050 after one month. This is a typical buy-back or repo (repurchase) transaction so common in conventional banking¹⁰.

The Issue of Freedom from Gharar

Defining Gharar

Gharar, unlike riba, does not have a consensus definition. In broad terms, it connotes risk and uncertainty. It is useful to view gharar as a continuum of risk and uncertainty wherein the extreme point of zero risk is the only point that is well-defined. Beyond this point, gharar becomes a variable and the gharar involved in a real life contract would lie somewhere on this continuum. Beyond a point on this continuum, risk and uncertainty or gharar becomes unacceptable¹¹. Jurists have attempted to identify such situations involving forbidden gharar. A major factor that contributes to gharar is inadequate information (jahl) which increases uncertainty. This is when the terms of exchange, such as, price, objects of exchange, time of settlement etc. are not well-defined. Gharar is also defined in terms of settlement risk or the uncertainty surrounding delivery of the exchanged articles.

Islamic scholars have identified the conditions which make a contract uncertain to the extent that it is forbidden. Each party to the contract must be clear as to the quantity, specification, price, time, and place of delivery of the contract. A contract, say, to sell fish in the river involves uncertainty about the subject of exchange, about its delivery, and hence, not Islamically permissible. The need to eliminate any element of uncertainty inherent in a contract is underscored by a number of traditions¹².

An outcome of excessive gharar or uncertainty is that it leads to the possibility of speculation of a variety which is forbidden. Speculation in its worst form, is gambling. The holy Quran and the traditions of the holy prophet explicitly prohibit gains made from games of chance which involve unearned income. The term used for gambling is maisir which literally means getting something too easily, getting a profit without working for it. Apart from pure games of chance, the holy prophet also forbade actions which generated unearned incomes without much productive efforts¹³.

Here it may be noted that the term speculation has different connotations. It always involves an attempt to predict the future outcome of an event. But the process may or may not be backed by collection, analysis and interpretation of relevant information. The former case is very much in conformity with Islamic rationality. An Islamic economic unit is required to assume risk after making a proper assessment of risk with the help of information. All business decisions involve speculation in this sense. It is only in the absence of information or under conditions of excessive gharar or uncertainty that speculation is akin to a game of chance and is reprehensible.

Gharar & Speculation with of Futures & Forwards

Considering the case of the basic exchange contracts highlighted in section 1, it may be noted that the third type of contract where settlement by both the parties is deferred to a future date is forbidden, according to a large majority of jurists on grounds of excessive gharar. Futures and forwards in currencies are examples of such contracts under which two parties become obliged to exchange currencies of two different countries at a known rate at the end of a known time period. For example, individuals A and B commit to exchange US dollars and Indian rupees at the rate of 1: 22 after one month. If the amount involved is $50 and A is the buyer of dollars then, the obligations of A and B are to make a payments of Rs1100 and $50 respectively at the end of one month. The contract is settled when both the parties honour their obligations on the future date.

Traditionally, an overwhelming majority of Sharia scholars have disapproved such contracts on several grounds. The prohibition applies to all such contracts where the obligations of both parties are deferred to a future date, including contracts involving exchange of currencies. An important objection is that such a contract involves sale of a non-existent object or of an object not in the possession of the seller. This objection is based on several traditions of the holy prophet¹⁴. There is difference of opinion on whether the prohibition in the said traditions apply to foodstuffs, or perishable commodities or to all objects of sale. There is, however, a general agreement on the view that the efficient cause (illa) of the prohibition of sale of an object which the seller does not own or of sale prior to taking possession is gharar, or the possible failure to deliver the goods purchased.

Is this efficient cause (illa) present in an exchange involving future contracts in currencies of different countries? In a market with full and free convertibility or no constraints on the supply of currencies, the probability of failure to deliver the same on the maturity date should be no cause for concern. Further, the standardized nature of futures contracts and transparent operating procedures on the organized futures markets¹⁵ is believed to minimize this probability. Some recent scholars have opined in the light of the above that futures, in general, should be permissible. According to them, the efficient cause (illa), that is, the probability of failure to deliver was quite relevant in a simple, primitive and unorganized market. It is no longer relevant in the organized futures markets of today¹⁶. Such contention, however, continues to be rejected by the majority of scholars. They underscore the fact that futures contracts almost never involve delivery by both parties. On the contrary, parties to the contract reverse the transaction and the contract is settled in price difference only. For example, in the above example, if the currency exchange rate changes to 1: 23 on the maturity date, the reverse transaction for individual A would mean selling $50 at the rate of 1:23 to individual B. This would imply A making a gain of Rs50 (the difference between Rs1150 and Rs1100). This is exactly what B would lose. It may so happen that the exchange rate would change to 1:21 in which case A would lose Rs50 which is what B would gain. This obviously is a zero-sum game in which the gain of one party is exactly equal to the loss of the other. This possibility of gains or losses (which theoretically can touch infinity) encourages economic units to speculate on the future direction of exchange rates. Since exchange rates fluctuate randomly, gains and losses are random too and the game is reduced to a game of chance. There is a vast body of literature on the forecastability of exchange rates and a large majority of empirical studies have provided supporting evidence on the futility of any attempt to make short-run predictions. Exchange rates are volatile and remain unpredictable at least for the large majority of market participants. Needless to say, any attempt to speculate in the hope of the theoretically infinite gains is, in all likelihood, a game of chance for such participants. While the gains, if they materialize, are in the nature of maisir or unearned gains, the possibility of equally massive losses do indicate a possibility of default by the loser and hence, gharar.

Risk Management in Volatile Markets

Hedging or risk reduction adds to planning and managerial efficiency. The economic justification of futures and forwards is in term of their role as a device for hedging. In the context of currency markets which are characterized by volatile rates, such contracts are believed to enable the parties to transfer and eliminate risk arising out of such fluctuations. For example, modifying the earlier example, assume that individual A is an exporter from India to US who has already sold some commodities to B, the US importer and anticipates a cashflow of $50 (which at the current market rate of 1:22 mean Rs 1100 to him) after one month. There is a possibility that US dollar may depreciate against Indian rupee during these one month, in which case A would realize less amount of rupees for his $50 ( if the new rate is 1:21, A would realize only Rs1050 ). Hence, A may enter into a forward or future contract to sell $50 at the rate of 1:21.5 at the end of one month (and thereby, realize Rs1075) with any counterparty which, in all probability, would have diametrically opposite expectations regarding future direction of exchange rates. In this case, A is able to hedge his position and at the same time, forgoes the opportunity of making a gain if his expectations do not materialize and US dollar appreciates against Indian rupee (say, to 1:23 which implies that he would have realized Rs1150, and not Rs1075 which he would realize now.) While hedging tools always improve planning and hence, performance, it should be noted that the intention of the contracting party - whether to hedge or to speculate, can never be ascertained.

It may be noted that hedging can also be accomplished with bai salam in currencies. As in the above example, exporter A anticipating a cash inflow of $50 after one month and expecting a depreciation of dollar may go for a salam sale of $50 (with his obligation to pay $50 deferred by one month.) Since he is expecting a dollar depreciation, he may agree to sell $50 at the rate of 1: 21.5. There would be an immediate cash inflow in Rs 1075 for him. The question may be, why should the counterparty pay him rupees now in lieu of a promise to be repaid in dollars after one month. As in the case of futures, the counterparty would do so for profit, if its expectations are diametrically opposite, that is, it expects dollar to appreciate. For example, if dollar appreciates to 1: 23 during the one month period, then it would receive Rs1150 for Rs 1075 it invested in the purchase of $50. Thus, while A is able to hedge its position, the counterparty is able to earn a profit on trading of currencies. The difference from the earlier scenario is that the counterparty would be more restrained in trading because of the investment required, and such trading is unlikely to take the shape of rampant speculation.

Summary and Conclusion

Currency markets of today are characterized by volatile exchange rates. This fact should be taken note of in any analysis of the three basic types of contracts in which the basis of distinction is the possibility of deferment of obligations to future. We have attempted an assessment of these forms of contracting in terms of the overwhelming need to eliminate any possibility of riba, minimize gharar, jahl and the possibility of speculation of a kind akin to games of chance. In a volatile market, the participants are exposed to currency risk and Islamic rationality requires that such risk should be minimized in the interest of efficiency if not reduced to zero.

It is obvious that spot settlement of the obligations of both parties would completely prohibit riba, and gharar, and minimize the possibility of speculation. However, this would also imply the absence of any technique of risk management and may involve some practical problems for the participants.

At the other extreme, if the obligations of both the parties are deferred to a future date, then such contracting, in all likelihood, would open up the possibility of infinite unearned gains and losses from what may be rightly termed for the majority of participants as games of chance. Of course, these would also enable the participants to manage risk through complete risk transfer to others and reduce risk to zero. It is this possibility of risk reduction to zero which may enable a participant to earn riba. Future is not a new form of contract. Rather the justification for proscribing it is new. If in a simple primitive economy, it was prevention of gharar relating to delivery of the exchanged article, in todays' complex financial system and organized exchanges, it is prevention of speculation of kind which is unIslamic and which is possible under excessive gharar involved in forecasting highly volatile exchange rates. Such speculation is not just a possibility, but a reality. The precise motive of an economic unit entering into a future contract - speculation or hedging may not ascertainable ( regulators may monitor end use, but such regulation may not be very practical, nor effective in a free market). Empirical evidence at a macro level, however, indicates the former to be the dominant motive.

The second type of contracting with deferment of obligations of one of the parties to a future date falls between the two extremes. While Sharia scholars have divergent views about its permissibility, our analysis reveals that there is no possibility of earning riba with this kind of contracting. The requirement of spot settlement of obligations of atleast one party imposes a natural curb on speculation, though the room for speculation is greater than under the first form of contracting. The requirement amounts to imposition of a hundred percent margin which, in all probability, would drive away the uninformed speculator from the market. This should force the speculator to be a little more sure of his expectations by being more informed. When speculation is based on information it is not only permissible, but desirable too. Bai salam would also enable the participants to manage risk. At the same time, the requirement of settlement from one end would dampen the tendency of many participants to seek a complete transfer of perceived risk and encourage them to make a realistic assessment of the actual risk.

Notes & References:

1. These diverse views are reflected in the papers presented at the Fourth Fiqh Seminar organized by the Islamic Fiqh Academy, India in 1991 which were subsequently published in Majalla Fiqh Islami, part 4 by the Academy. The discussion on riba prohibition draws on these views.
    
2. Nabil Saleh, Unlawful gain and Legitimate Profit in Islamic Law, Graham and Trotman, London, 1992, p 16.
    
3. Ibn Qudama, al-Mughni, vol.4, pp 5-9.
    
4. Shams al Din al Sarakhsi, al-Mabsut, vol 14, pp 24-25.
    
5. Paper presented by Abdul Azim Islahi at the Fourth Fiqh Seminar organized by Islamic Fiqh Academy, India in 1991.
    
6. Paper by Dr M N Siddiqui highlighting the issue was circulated among all leading Fiqh scholars by the Islamic Fiqh Academy, India for their views and was the main theme of deliberations during the session on Currency Exchange at the Fourth Fiqh Seminar held in 1991.
    
7. It is contended by some that the above example may be modified to show the possibility of riba with spot settlement too. "In a given moment in time when the market rate of exchange between dollar and rupee is 1:20, if an individual purchases $50 at the rate of 1:22 (settlement of his obligation also on a spot basis), then it amounts to the seller of dollars exchanging $50 with $55 on a spot basis (Since, he can obtain Rs 1100 now, exchange them for $55 at spot rate of 1:20)" Thus, spot settlement can also be a clear source of riba. Does this imply that spot settlement should be proscribed too? The fallacy in the above and earlier examples is that there is no single contract but multiple contracts of exchange occurring at different points in time (true even in the above case). Riba can be earned only when the spot rate of 1:20 is fixed during the time interval between the transactions. This assumption is, needless to say, unrealistic and if imposed artificially, perhaps unIslamic.
    
8. Islam envisages a free market where prices are determined by forces of demand and supply. There should be no interference in the price formation process even by the regulators. While price control and fixation is generally accepted as unIslamic, some scholars, such as, Ibn Taimiya do admit of its permissibility. However, such permissibility is subject to the condition that price fixation is intended to combat cases of market anomalies caused by impairing the conditions of free competition. If market conditions are normal, forces of demand and supply should be allowed a free play in determination of prices.
    
9. Some Islamic scholars use the term forward to connote a salam sale. However, we use this term in the conventional sense where the obligations of both parties are deferred to a future date and hence, are similar to futures in this sense. The latter however, are standardized contracts and are traded on an organized Futures Exchange while the former are specific to the requirements of the buyer and seller.
    
10. This is known as bai al inah which is considered forbidden by almost all scholars with the exception of Imam Shafii. Followers of the same school, such as Al Nawawi do not consider it Islamically permissible.
     
11. It should be noted that modern finance theories also distinguish between conditions of risk and uncertainty and assert that rational decision making is possible only under conditions of risk and not under conditions of uncertainty. Conditions of risk refer to a situation where it is possible with the help of available data to estimate all possible outcomes and their corresponding probabilities, or develop the ex-ante probability distribution. Under conditions of uncertainty, no such exercise is possible. The definition of gharar, Real-life situations, of course, fall somewhere in the continuum of risk and uncertainty.
     
12. The following traditions underscore the need to avoid contracts involving uncertainty.
    Ibn Abbas reported that when Allah's prophet (pbuh) came to Medina, they were paying one and two years advance for fruits, so he said: "Those who pay in advance for any thing must do so for a specified weight and for a definite time".
    
    It is reported on the authority of Ibn Umar that the Messenger of Allah (pbuh) forbade the transaction called habal al-habala whereby a man bought a she-camel which was to be the off-spring of a she-camel and which was still in its mother's womb.
     
13. According to a tradition reported by Abu Huraira, Allah's Messenger (pbuh) forbade a transaction determined by throwing stones, and the type which involves some uncertainty.
    
    The form of gambling most popular to Arabs was gambling by casting lots by means of arrows, on the principle of lottery, for division of carcass of slaughtered animals. The carcass was divided into unequal parts and marked arrows were drawn from a bag. One received a large or small share depending on the mark on the arrow drawn. Obviously it was a pure game of chance.
     
14. The holy prophet is reported to have said " Do not sell what is not with you"
    Ibn Abbas reported that the prophet said: "He who buys foodstuff should not sell it until he has taken possession of it." Ibn Abbas said: "I think it applies to all other things as well".
     
15. The Futures Exchange performs an important function of providing a guarantee for delivery by all parties to the contract. It serves as the counterparty in the exchange for both, that is, as the buyer for the sale and as the seller for the purchase.
     
16. M Hashim Kamali "Islamic Commercial Law: An Analysis of Futures", The American Journal of Islamic Social Sciences, vol.13, no.2, 1996.

The Birth of Euro Currency

The euro was developed in an effort to "create one of the largest and most powerful economic areas of the world". The euro was introduced on January 1, 2002 to 12 European countries. These countries included Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. While there were many beneficial reasons for European countries to unite and switch to a single currency, one must ask why Great Britain, Sweden, and Denmark chose not to adopt it. Did cultural, economic or political reasons play a part in this decision or was it a combination?

A major catalyst to the acceleration of Forex trading was the rapid development of the euro-dollar market, where US dollars are deposited in banks outside the USA border. Similarly, the European market are those where assets are deposited outside the currency rightful owner country market. The euro-dollar market first came into being in the 1950s when Russia's oil revenue — all in dollars — was deposited outside the US in fear of being frozen by US regulators. That gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government imposed laws to restrict dollar lending to foreigners. European markets were particularly attractive because they had far less regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow offshore, finding Euromarkets a beneficial center for holding excess liquidity, providing short-term loans and financing imports and exports.

The European Market

The changeover to the euro is the largest monetary changeover in world history, and it is the culmination of a process begun decades ago. The introduction of the euro as a circulating currency is the realization of a Europe in which people, services, capital and goods can move freely. Such a common European market was envisioned back in 1957 with the Treaty of Rome. It declared a common European market to be a European objective with the aim of increasing economic prosperity and contributing to a closer union among the peoples of Europe.

Planning for its implementation began in 1957 with the signing of the Treaty of Rome. This was a little over four decades prior to the euro's actual introduction on January 1, 2002. The Treaty of Rome "declared a common European market to be a European objective with the aim of increasing economic prosperity and contributing to a closer union among the peoples of Europe".

In 1979 the European Monetary System (EMS) went into operation. The EMS "was designed to create a zone of monetary stability in Europe, control inflation, and coordinate exchange rate policies of EU countries." (Hill 676) "It used a mechanism called the European currency unit (ECU). The ECU is an entity that is used for accounting purposes only". At that time, there were only eight member nations that agreed to hold exchange rates within certain limits.

Next, the Single European Act was signed in 1986. This act revised the objectives of the Treaty of Rome and was a commitment to create a single market by the end of 1992. Subsequently, the heads of state and government of the European Community asked the European Commission to develop a schedule for the implementation of a common currency.

The Treaty on European Union was agreed to in Maastrict in 1991. It went into effect in November 1993 after ratification of the member states. It called for an economic and monetary union by 1999 as well as a political union including foreign and security policy. This set the date for the launch of the common currency in the European Union (EU). However, Great Britain and Denmark negotiated to keep their national currencies. Sweden opted out at a later time.

The European single market was achieved as of January 1, 1993. In 1995 the European Council adopted the name euro for the single currency. Then in 1998 eleven EU member states qualified to be part of the Economic and Monetary Union when it began on January 1, 1999. Greece joined as the 12^th member in January 2001.

The European Central Bank was also inaugurated in June 1998 in Frankfurt, Germany. The European Central Bank is part of the European System of Central Banks. Their primary mission is to maintain price stability and conduct monetary policy for the euro area. They were also responsible for managing the development and introduction of the euro.

The euro was adopted by 11 member states of the euro area on January 1, 1999. This is when the European Economic and Monetary Union (EMU) went into operation with the euro. At this point, the exchange rates of participating currencies were set and the 11 member states began implementing a common monetary policy. Finally, on "January 1, 2001 the euro was introduced as legal tender and old currency could no longer be used for non-cash transactions, such as checks and bank transfers".

One common denominator throughout the planning and preparation of the introduction to the euro is that six countries remained involved throughout the entire process. These countries included Belgium, Denmark, Germany, Spain, France, Luxembourg, Netherlands, and Ireland. It appears that each one of these countries was motivated to introduce the euro in an effort to try to stabilize the economy and promote trade.

In addition to all of the careful planning and preparation, a very detailed implementation plan was created to ensure a smooth rollout of the euro. From January 1, 1999 - December 31, 2001, the euro could only be used for non-cash transactions. There were no euro notes or coins in circulation at this time. However, price tags, bank statements and other documents and systems began reflecting amounts in euros. Additionally, the conversion rates for national currencies of the member states and euro were fixed.

In preparation for the changeover, euro notes and coins were delivered to banks in the 12 member states in September 2001. At this point in time, the banks began distributing the euro notes and coins to retailers and other institutions. Then in December 2001 the euro coins were distributed by banks to the general public. "In Germany, people were given the option to exchange 20 DM for a "starter kit" containing €10.23 in coins".

On January 2002, euro notes and coins entered circulation as legal tender in the euro zone. Conversion of all bank accounts and corporate books in the euro area were completed. Finally, all salary and social security transactions and all new contracts were transacted in euro.

Between January 1, 2002 and February 28, 2002 the euro as well as old currencies was accepted in most euro-area countries. Consumers had the option to make purchases using the old currencies, but received their change in euros. The aim at this time was to have most cash transactions made in euro by mid-January 2001.

Given the difficulty and length of implementation, there must have been compelling reasons for these countries to agree to switch to one common currency. Overall it was felt that the main benefit was that a single market needs a single currency. In fact, some of the main marketing slogans used by the European Monetary Union prior to the introduction of the euro were "one market, one money" and "the value of the euro is the value of Europe".

Surprisingly, businesses wanted the euro. Adopting the euro lowered their transaction costs through eliminating the cost and administrative overhead of exchanging currencies between one country and another. It also eliminated currency exchange rate risk. The introduction of the "euro also lifted barriers to free trade in goods, services, labor and capital". As a result, they realized lower prices for products and services. Another added benefit is that the euro made it much easier to compare prices for the same goods and services between countries. This not only helps the business but customers as well.

ref: http://www.germany.info/relaunch/info/publications/infocus/euro/welcome.html

Why the Euro? Objectives of European Monetary Union

"The value of the euro is the value of Europe."

For the first time since the Roman empire Europe - from Lapland to Portugal - will share a common legal tender. The introduction of the euro and the completion of the common market will create one of the largest and most powerful economic areas in the world. With a population of 303 million, the euro zone is markedly larger than its closest competitors, the U.S. (276 million) and Japan (127 million). The euro area contributes 16% of global GDP, the U.S. 22% and Japan 7%. The euro also will give new impetus to political unification.

There are numerous objectives to European Monetary Union:

• Price Stability
• International Market Equilibrium
• Budgetary Discipline
• Economic Growth and Reform

The advent of the euro has lifted barriers to free trade in goods, services, labor and capital. This gives companies throughout Europe a more reliable means of calculating trade and investments. Consumers will profit from greater competition and price transparency throughout the euro area. The expanded financial markets created by the introduction of the single currency will likely open more investment opportunities. Moreover, the euro is likely to become a major currency reserve for other countries, with important macroeconomic implications.

Nearly three years after its introduction as a trading currency, the euro has proven a positive factor for economic policy despite the current weak worldwide economic environment. The euro lifts the last hurdles to true European integration and allows unimpeded and efficient exchange of goods, services, labor and capital. The macroeconomic political branches have reacted calmly and appropriately to fluctuations in the overall economic situation. This indicates that a reliable and trustworthy stability structure has developed in recent years. Moreover, the euro has improved the prospects for a swifter recovery from current economic troubles. The 12 EU member states are bound closely by their common market and their common currency. The introduction of the single cash currency to consumers in all 12 countries on January 1, 2002 should tighten this cooperation and reinforce the strength of this powerful new economic presence.

Price Stability

Europe's history sets the backdrop for the chief objective of the single European currency: price stability. In the first half of the 20th century, wild price fluctuations wreaked havoc on European economic and political stability. After World War I, prices in Germany skyrocketed, leading to the precarious conditions that in part gave rise to the Second World War. In 1948, the deutschmark was created with the express intention of controlling inflation. For several decades, the German Bundesbank (the federal reserve bank) has been entrusted with this goal.

The institution charged with safeguarding medium-term price stability in the euro zone is the European Central Bank (ECB), modeled on the German Bundesbank and headquartered in Frankfurt. In the words of its president, Wim Duisenberg, "The people of Europe need to be confident that their new currency can sustain its value over time and that the ECB is an institution they can trust." The approach is based on a broad consensus among central banks - not just in Europe but worldwide - that the best macroeconomic contribution monetary policy can make toward improving the economic outlook and raising standards of living is to credibly maintain price stability. The ECB has defined "price stability" as an increase of the euro area consumer price index of less than 2%.

International Market Equilibrium

A stable common currency is the keystone of European monetary union. The effects of the September 11 terrorist attacks made clear how vital the broad-based euro is to the stability of world financial markets. In the days following the attacks, the euro-dollar exchange rate remained remarkably constant, at roughly €1=US$ 0.90. Without the euro, foreign exchange markets might have been shaken into crisis. Moreover, slowing economic growth around the world gives the European common market new significance. Economic experts put euro zone GDP growth at 1.7% in 2001 and at 1.8% in 2002, considerably faster than projected U.S. and Japanese economic growth in the same periods. Thus the euro area can play a significant role in shoring up and stabilizing a weakening world economy.

The euro is worth more than just the sum of its parts. The region's say in the further development of the world trade and finance system has been bolstered considerably by the advent of its single currency. Due to the massive size of this market, the euro is the second most important trading currency, offering a credible alternative to the U.S. dollar. Moreover, the euro zone capital market is the second largest and second most liquid in the world. International acceptance of the euro should also reflect the importance of the euro zone in the globalized economy.

The role of the euro as a trading and reserve currency can be developed much further. Roughly 60% of all world trade is now conducted in U.S. dollars, just 15% in euros. However, within the euro zone, this number jumps to 70%. International reserves also remain largely in dollars (66%) rather than euros (13%). ECB officials are optimistic that this will change once the euro is introduced as the single legal cash currency of the 12 euro countries. This is already happening. China, for example, announced in November 2001 that it had been buying euros for the last two months and intended to increase the single currency's share in its immense $200 billion foreign exchange reserves.

Monetary union means that exchange-rate adjustments are no longer possible in the euro area. The exchange-rate distortions caused by external shocks throughout Europe's history, and the attendant expansion of interest-rate spreads, are both things of the past. This makes investment in the euro zone safer and more calculable.

One of the euro's biggest coups has come in the euro bond market. Sharing one large currency zone has allowed euro-zone companies to raise huge amounts of money to finance investments and expansion. The euro bond market has overtaken the dollar bond market in size and given the region's industries a huge boost.

Budgetary Discipline

All euro member nations were required to meet strict economic stability criteria to gain admission to European monetary union. The Stability and Growth Pact that governs the individual states ensures that these conditions are maintained. Debts and deficits have been reduced and stabilized through 2006. The single capital market and low inflation are designed to ensure low long-term interest rates. This should, in turn, attract additional investment and spur national structural reforms.

Economic Growth and Reform

Economic union exerts a healthy pressure for economic and financial policy change - even when they come up against various political interests. A faulty national economic and financial policy will now be "paid for" in terms of growth and employment more quickly and transparently than in the past. "The euro and globalization are exerting pressure on policies and markets in Europe to become more flexible," says Dr. Jürgen Stark, deputy governor of the Bundesbank. "At the same time, however, the reforms will - in the medium to long term - accelerate the pace of economic growth and enhance the attractiveness of the euro area as well as the single currency."

Germany has reacted to this pressure and the economy has benefited. In the 1990s, during the lead-up to euro, many state-owned enterprises were privatized, and markets were liberalized and deregulated, particularly in high-growth telecommunications, media and energy sectors. Taxes and pensions have been reformed to invigorate the economy. "Monetary union requires flexibility at a national level," says Dr. Stark, "since exchange rates are no longer available as an adjustment parameter."

Responsible wage policy will pay higher dividends in the future. More investment should ultimately lead to more growth and, given the right conditions in the labor markets, higher employment. A large part of German and European unemployment is caused by structural factors. The intensifying competition within the euro area will, however, demand increased flexibility of labor and goods markets. A stability-oriented budgetary policy by the ECB improves the scope for promoting growth and employment while guaranteeing price stability.

Finally, the disappearance of transaction costs can boost economic growth and make goods cheaper for consumers. Smaller firms in the euro zone are finding customers in regions they previously never bothered to export to. According to most recent estimates, monetary union will bring savings equal to 1% of total euro area GDP, as currency transaction costs are done away with. In Germany alone, this amounts to €20 billion.

ref: http://www.germany.info/relaunch/info/publications/infocus/euro/welcome.html

Why Great Britain, Sweden and Denmark chose not to adopting the Euro

While there clearly were advantages to adopting the euro, Great Britain, Sweden, and Denmark chose not to switch to a single currency. The following arguments from Great Britain illustrate many of the reasons that the other non-adopting countries identified. Some of these examples do not universally apply but are indicative of the scope of the problem.

First, Great Britain was afraid that switching to the euro would mean giving up control of their economy. As a result, they would lose flexibility to switch their own interest rates if economic conditions warranted movement of the rate. Instead of being able to respond quickly to the economic environment these countries would have to wait for the EMU to review and decide on each the situation.

Case in point, the British economy is different compared to the rest of the European countries.

"Britain does more of their trade (57 percent) with countries outside the Eurozone. They also receive large amounts of their investment from the United States. The Bank of England currently sets interest rates according to the needs of the British economy. Inside the euro we would have to accept a single interest rate set by the European Central Bank in Frankfurt which would usually be wrong for us<".

As a result, Britain was adamant that they needed different policies in order to set policy on interest rates, taxes and spending.

Another consideration was the economic performance of the country. According to the Organization for Economic Cooperation and Development (OECD), as of 2002, Britain had the best outlook of any country. They also had the highest gross domestic product (GDP) per head than both Germany and France. Additionally, they had the lowest inflation in the European Union (EU) along with the highest take home pay. Obviously, they did not want to put the positive aspects of their economic environment at risk. The risks associated with adopting a single currency far outweighed the proposed benefits.

As an example, there was a strong sentiment in the British community that it was not necessary to adopt the euro in order to trade with Europe. For two years beginning in 1990 the British pound was linked with Europe in the Exchange Rate Mechanism with disastrous consequences; unemployment doubled and 100,000 businesses were lost. When contemplating adopting the euro they did not want to make the same mistake again.

The reality of multiple countries adopting the euro required each country to assume the same tax base. This was required regardless of the each country's economic environment at that time. Without a doubt, some countries benefited while others did not. Taxes in some product categories such as cigarettes and alcohol lowered but overall they increased by over 16%. The British economy was thriving in its own right. Unemployment was lower in Britain than in the countries that adopted the euro. Great Britain's economy experienced lower inflation. Also, Great Britain received more foreign investment than both Germany and France combined. Assuming the same tax base would have a negative impact on Great Britain's favorable economic environment.

Great Britain does more of their trade in dollars than euros. At the time the euro was being considered for adoption, it was believed that doing so would destabilize British trade.

Another argument against Great Britain adopting the euro had to do with the financial solvency of other countries. For example, several of the major euro economies had bankrupt state pension systems. Adopting the euro would dilute the solvency of Great Britain's pension systems and therefore would not be economically viable.

Adopting countries had a strong incentive to move forward because of significant inadequacies of economic base conditions such as their public services infrastructures. They saw the euro as a solution to streamline infrastructure improvements. Conversely, Great Britain did not have the same inadequacies and therefore predicted that adoption of the euro would erode the quality of the same infrastructure categories. "In February 2002, the Government was warned by the European Commission that if they were inside the euro, they would have had to cut spending on public services by £10 billion to comply with the spending rules of the euro".

Most alarmingly, people controlling euro economic policy are not elected officials. Great Britain highly values their ability to vote out those in control of economic policy when it is determined that they are not performing. They feel that adopting the euro erodes more than the economical base; it erodes the political base as well. "In the Eurozone it is openly admitted that the aim of the European Monetary Union (EMU) is political union. A single currency is the first step towards a single state. Inside the euro, economic decisions would be made by unelected officials in Brussels and Frankfurt".

Opinion

Smaller countries with detrimental infrastructures and economic bases are highly motivated to have a single currency. Fundamentally, one of the major advantages of an elective political system is that the people have the control to correct incidents of corruption and poor leadership. By its very nature the architecture of the way people are put into the position to control the euro is missing the correcting mechanism as a part of its structure. Commensurately, how can a major economic power such as Great Britain, Sweden, or Denmark safely adopt such a system without elected officials? Could it be possible that if the wrong person gained power over euro economic policy that the whole system could collapse?

Although the arguments presented in this paper do not apply to all three countries that opted out of the euro, they are representative of some of the key issues and concerns they all faced. The major reasons given by Great Britain indicated they were primarily concerned with economic factors, followed closely by the political concern of not having the right to elect the officials that control euro economic policy. The British community wanted to remain in control of their economy so they could quickly respond to changes in their economic environment. Furthermore, they wanted to ensure they did not go through the same economic turmoil as they experienced when the British pound was linked to the Exchange Rate Mechanism. After weighing the pro's and con's Britain, Denmark, and Sweden concluded that the risks associated with adopting the euro far outweighed the proposed benefits. As a result, they chose to continue to use their national currency and still do to this day.

ref: http://www.no-euro.com/whatwebelieve/%20tenreasons.asp

Brazilian Real Crisis

In 1993 the Real Plan was introduced in Brazil as a stabilization package. The plan controlled existing hyper-inflation conditions, balanced the fiscal budget, and reduced federal expenditures. Most importantly, the plan introduced a new currency, the Real, which was pegged to the dollar.

Although the currency was successful in calming inflation, it was not enough to reconcile the discrepancy between Brazilian and U.S. Inflation rates. As a result the Real became overvalued, which made imports cheaper to buy and exports harder to sell abroad. In turn, the overvalued currency led to a current account deficit whereby the number of imports far exceeds exports. The huge deficit was more than offset by foreign investors' appetite for Brazilian assets, which attracted a huge inflow of foreign capital, and brought reserves in excess of 70 billion in the 1990s. Because the currency was so dependent on foreign investments to prop up its value, it was very vulnerable to a currency crisis if investors remove their funds at a rapid rate. Such conditions, which triggered a mass exodus of funds and led to the Real devaluation were:

• Financial Contagion: The Real was exposed to financial contagion. Contagion is a condition whereby a financial crisis in one country triggers widespread fear with investors, thus causing them to remove funds from other countries with comparable problems. The Asian Currency crisis, Russian crisis and the Mexican Peso Crisis were events that preceded the collapse of the Real. As investors liquidated their capital out of these countries, they also repatriated their funds from Brazil. One month before the crisis, funds were repatriated at an estimated $350 billion per day.
• Dollar-peg: In order to maintain the peg to the dollar, a central bank has the right to intervene in order to stabilize the value of the currency. Brazil's reserves fell from a high of 70 billion in the beginning of 1998 to half its value by year-end in order to maintain the value of the peg.
• Fiscal Problems: Interest rates were raised to almost 50% in order to try to prevent investors from removing their funds. However, this was not enough to mask the underlying structural problems of an overvalued currency. Raising interest rates only exacerbated the current account deficit numbers.

By 1999, Brazil decided to throw out its dollar-peg and let the Real devalue.

The real plunged 44% by January 29, 1999. The crisis showed that economic calamity in one country could easily spill over into other economies with similar problems.

Asian Financial Crisis

The Asian financial crisis was a financial crisis that started in July 1997 in Thailand and affected currencies stock markets and other asset prices of several Asian countries many part of the East Asian Tigers . It is also commonly referred to as the Asian Currency Crisis.

Indonesia, South Korea and Thailand were the countries most affected by the crisis with Malaysia, Philippines and Hong Kong also hit by the slump. Mainland China and Taiwan were relatively unaffected. Japan was not affected much by this crisis but was going through its own ongoing long-term economic difficulties.

History

Until 1996 Asia attracted almost half of total capital inflow to developing countries. However Thailand Indonesia and South Korea had large current account deficits and the maintenance of pegged exchange rate encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors.

The Asian crisis started in mid-1997 and affected currencies stock markets and other asset prices of several South East Asian economies. Triggered by events in Latin America Western investors lost confidence in securities in East Asia and began to pull money out creating a snowball effect.

Thailand

From 1985 to 1995 Thailand's economy grew at an average of 9%. On May 14 and May 15 1997 the baht the local currency was hit by massive speculative attacks. On June 30 Prime Minister Chavalit Yonchaiyudh said that he would not devaluate the baht but Thailand's administration eventually floated the local currency on July 2.

In 1996 an American hedge fund had already sold $400 million of the Thai currency. From 1985 until July 2 1997 the baht was pegged at 25 to the dollar. The baht dropped very swiftly and lost half of its value. The baht reached its lowest point of 56 to the dollar in January 1998. Thai stock market dropped 75% in 1997. Finance One the largest Thai finance company collapsed. On August 11 the IMF unveiled a rescue package for Thailand with more 16 billion dollars. The IMF approved on August 20 another bailout package of 3.9 billion dollars.

Philippine

The Philippines central bank raised interest rates by 1.75 percentage points in May and again by 2 points on June 19. Thailand triggered the crisis on July 2. On July 3 the Philippines central bank was forced to intervene heavily to defend the peso raising the overnight rate from 15 percent to 24 percent.

Hong Kong

In October 1997 the Hong Kong dollar which was also pegged at 7.8 to the US dollar came under speculative pressure since Hong Kong's inflation rate was significiantly higher than that of the US for years. Monetary authorities spent more than US$1 billion to defend the local currency. Despite the speculative attacks Hong Kong managed to keep the currency pegged to the US dollar. Stock markets become more and more volatile between October 20 and October 23 Hang Seng Index dipped by 23%. Hong Kong Monetary Authority and the People's Republic of China promised to protect the currency. On August 15 1997 Hong Kong raised overnight rates from 8 percent to 23 percent.

South Korea

South Korea is the world's 11th largest economy. Macroeconomic fundamentals were good but the banking sector was burdened with non-performing loans. Excess debt will eventually lead to major failures and take-overs. For example in July South Korea's third largest car maker Kia Motors asked for emergency loans. In the wake of the Asian market downturn Moody's lowered the credit rating of South Korea from A1 to A3 on November 28 1997 and downgraded again to Baa2 on December 11 . That contributed to a further decline in Korean shares since stock markets were already bearish in November. Seoul stock exchange fell by 4 percent on November 7 1997. On November 8 it plunged by 7 percent the biggest one-day drop ever recorded there to date. And on November 24 stocks fell another 7.2 percent on fears that the IMF may demand tough reforms. In 1998 Hyundai Motor took over Kia Motors.

Malaysia

In 1997 Malaysia had a large current account deficit of over 6 percent of GDP. In July the Malaysian ringgit was attacked by speculators . Malaysia floated its currency on August 17 1997 and the ringgit fell sharply. Four days later Standard & Poor's downgraded the debt rating of Malaysia. A week later the rating agency downgraded the rating of Maybank the largest bank of Malaysia. The same day the Kuala Lumpur Stock Exchange's plunged at 856 points its lowest point since 1993. On October 2 the ringgit dropped again. Prime Minister Mahathir Mohamad introduced capital controls. However the currency collapsed again in late 1997 when Mahathir Mohamad announced that the government would spend 10 billion ringgit in a road rail and pipeline project.

In 1998 output of most sectors declined. The construction sector contracted 23.5 percent manufacturing shrunk 9 percent and the agriculture sector 5.9 percent. Malaysia's gross domestic product plunged 6.2 percent in 1998. Malaysia emerged as the fastest country to overcome the crisis after declining IMF assistance.

Indonesia

In June 1997 Indonesia seemed far from crisis. Unlike Thailand Indonesia had low inflation a trade surplus of more than 900 million dollars huge foreign exchange reserves of more than 20 billion dollar and a good banking sector.

But a large number of Indonesian corporations had been borrowing in U.S. dollars. During preceding years as the rupiah had strengthened respective to the dollar this practice had worked well for those corporations -- their effective levels of debt and financing costs had decreased as the local currency's value rose.

In July when Thailand floated the baht Indonesia's monetary authorities widened the rupiah trading band from 8 percent to 12 percent. The rupiah came under severe attack in August. On 14 August 1997 the managed floating exchange regime was replaced by a free-floating exchange rate arrangement. The rupiah dropped further. The IMF came forward with a rescue package of 23 billion dollar but the rupiah was sinking further amid fears over corporate debts massive selling of rupiah strong demand for dollars. The rupiah and Jakarta Stock Exchange touched a new historic low in September. Moody's eventually downgraded Indonesia's long-term debt to junk bond.

Although the rupiah crisis began in July and August it intensified in November when the effects of that summer devaluation showed up on corporate balance sheets. Companies that had borrowed in dollars had to face the higher costs imposed upon them by the rupiah's decline and many reacted by buying dollars i.e. selling rupiah undermining the value of the latter further.

The inflation of the rupiah and the resulting steep hikes in the prices of food staples led to riots throughout the country. In February 1998 president Suharto sacked the governor of Bank Indonesia but this proved insufficient. Suharto was forced to resign in mid-1998 and B.J. Habibie became president.

Mainland China

The People's Republic of China was largely not affected by the crisis because of the non-convertibility of the renminbi (RMB) and the fact that almost all of its foreign investment took the form of factories on the ground rather than securities. While the PRC had and continues to have severe solvency problems in their banking system most of the deposits in PRC banks are domestic and there was not a run on the banks.

The United States and Japan

The "Asian flu" also put pressure on the United States and Japan. Their economies did not collapse but they were severely hit.

On October 27 1997 the Dow Jones industrial plunged 554-point or 7.2 percent amid ongoing worries about the Asian economies. New York Stock Exchange briefly suspended trading. The crisis led to a drop in consumer and spending confidence.

Japan was affected because its economy is prominent in the region. Asian countries usually runs a trade deficit with Japan because the latter's economy is more than twice the size of the rest of Asia together and seven times China's. About 40 percent of Japan's exports go to Asia. GDP real growth rate slowed dramatically in 1997 from 5 percent to 1 6 percent and even sank into recession in 1998. The Asian financial crisis also led to more bankruptcies in Japan.

Consequences

The Asian crisis affected currencies stock markets and other asset prices of several Asian countries. Indonesia South Korea and Thailand were the countries most affected by the crisis. The economic crisis also led to political upheaval most notably culminating in the resignations of Suharto in Indonesia and Chavalit Yongchaiyudh in Thailand. There was a general rise in anti-Western sentiment with George Soros and the International Monetary Fund in particular singled out as scapegoats.

Culturally the Asian financial crisis killed the idea of Asian values which presumed that East Asia had found a political and economic structure that was superior to the West. The Asian crisis also raised the economic prestige of the People's Republic of China considerably.

The Asian crisis contributed to the Russian and Brazilian crisis in 1998 because after the Asian crisis banks were reluctant to lend to emerging countries.

Russian Financial Crisis

After the demise of the USSR in the latter part of the 20th century, the Russian economy was faced with the daunting task of completely rebuilding itself on political, philosophical, economic, strategic, and virtually all other grounds. While initial attempts at doing so had unsurprisingly brought about an economic crisis of sorts - Russia was mired in poverty and economic helplessness throughout most of 1991-1993 period - the country had a brief respite from economic maladies during the middle of the '90s, when foreign direct investment, coupled with political stimulus packages, worked to create what appeared to be the beginning of a new free market.

Unfortunately, though, Russia's crisis in 1998 has much of the same song and dance as other the Asian crises that wreaked havoc over an entire continent for much of the late '90s. As a developing nation, Russia - like the countries who eventually succumbed to the Asian currency crisis - was eager to establish relationships with already developed nations, nations that were looking for high growth investment opportunities. Accordingly, Russia sold debt to foreign investors, and allowed them to enjoy virtually unrestrained investment opportunities.

The result was that the Russian economy had become excessively dependent upon a sound global economy, as its capital flow model was based primarily on the existence of a demand for exports. When the currency crisis plagued Asian countries, though, Russia found that its strategy of using international investment to provide the fuel for internal growth was potentially doomed. The crisis in Asia resulted in plummeting prices for Russia's two most valuable sources of capital flows: energy and metals. Still a fragile economy, the rapid decline in the value of those two capital sources catapulted the entire economy into chaos: GDP tumbled, unemployment soared, and perhaps most painful, investors liquidated their Russian assets. The result was that the government was simply unable to pay back the debts it had issued, and IMF intervention was necessary.

As with all currency crises, the foreign exchange market was perhaps the greatest and most lethal predator of all, as its stranglehold on the market exchange rate ultimately dictated the crisis-enduring country's ability to access external help in its hour of need. On August 12 of 1998, Russia's central bank acknowledged this very fact, lamenting that the interbank market virtually paralyzed the ruble due to a lack of confidence and an unwillingness to create a liquid market for the currency. Russian Prime Minister Kiriyenko was particularly bothered by this, as he claimed there was no fundamental reason for the market to behave in a manner that resulted in such profound devaluation. Market uncertainty was reflected not only in the lack of liquidity, but in the excess volatility that ensued in its wake: the ruble made triple digit percentage moves on a regular basis, and given the decentralized nature of the foreign exchange market, its value was both erratic and subjective. Ultimately, the country relied on IMF assistance and massive changes in both fiscal and monetary policy to create a viable internal economy.

Today, Russia is still in the midst of rebuilding itself internally. Like many developing nations, its primary obstacle centers around the task of creating an infrastructure that allows creativity and entrepreneurial endeavors to flourish, but is not excessive to the point where it stifles growth. As the country rebuilds itself, it is slowly but surely inching its way back into the global economy and the powerful foreign exchange markets.

Dollar Devaluation And The Plaza Accord

After the demise of all the various exchange rate regulatory mechanisms that characterized the 20th century - i.e. the Gold Standard, the Bretton Woods Standard, and the Smithsonian Agreement — the currency market was left with virtually no regulation other than the mythical "invisible hand" of free market capitalism, one that supposedly strived to create economic balance through supply and demand. Unfortunately, due to a number of unforeseen economic events - such as the OPEC oil crises, stagflation throughout the '70s, and drastic changes in the US Federal Reserve's fiscal policy - supply and demand, in and of themselves, became insufficient means by which the currency markets could be regulated. A system of sorts was needed, but not one that was inflexible: fixation of currency values to a commodity, such as gold, proved to be too rigid for economic development, as was also the notion of fixing maximum exchange rate fluctuations. The balance between structure and rigidity was one that had plagued the currency markets throughout the 20th century, and while advancements had been made, a definitive solution was still greatly needed.

And hence in 1985, the respective Ministers of Finance and Central Bank Governors of the world's leading economies - France, Germany, Japan, the United Kingdom, and the United States - convened in New York City with the hopes of arranging a diplomatic agreement of sorts that would work to optimize the economic effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the international leaders came to certain agreements regarding specific economies and the international economy as a whole:

• Across the world, inflation was at very low levels. Contrary to the stagflation of the '70s - where inflation was high and real economic growth was low - the global economy in 1985 had done a complete 180, as inflation was now low but growth was strong.
• While low inflation, even when coupled with robust economic growth, still allowed for low interest rates - a caveat developing countries particularly enjoyed - there was an imminent danger of protectionist policies entering the economy. The US was experiencing a large and growing current account deficit, while Japan and Germany were facing large and growing surpluses. An imbalance so fundamental in nature could create serious economic disequilibrium, which in turn would result in a distortion of the foreign exchange markets and thus the international economy as a whole.
• The results of current account imbalances, and the protectionist policies that ensued, required action. Ultimately, it was believed that the rapid acceleration in the value of the US dollar was the culprit; a dollar with a lower valuation would be more conducive to stabilizing the international economy, as it would naturally bring about a greater balance between the exporting and importing capabilities of all countries.

And so for much of the remainder of the decade, the US dollar plummeted in value. The US economy became far more export-oriented as a result, while other industrial countries like Germany and Japan assumed the role of importing. This gradually resolved the current account deficits, and also ensured that protectionist policies were minimal and non-threatening. But perhaps most importantly, the Plaza Accord cemented the role of the central banks in regulating exchange rate movement: yes, the rates would not be fixed, and hence would be determined primarily by supply and demand; but ultimately, such an invisible hand is insufficient, and it was the right and responsibility of the world's central banks to intervene on behalf of the international economy when necessary.

OPEC & The International Oil Crisis Of The 1970s

The emergence of OPEC - the Organization of Petroleum Exporting Countries - in 1960 essentially shifted the oil market away from Western producers and into the hands of oil producers located primarily in the Middle East, which in turn led to a drastic shift in the pricing strategy and market demand for oil. In particular, prices for oil accelerated on a sharp upward slope from 1973 to 1979, when numerous wars in the Middle East — as well as a dwindling global supply coupled with increasing global demand — resulted in both geopolitical and economic factors dictating a substantially higher market price for oil.

While the entire world was affected by what essentially can be equated as a rise in the price of energy, the US economy found the dramatic rise in oil prices - an astounding 184% in just the first six months of 1974 - to be particularly detrimental: it created a unique situation known as stagflation, whereby the rise in oil prices resulted in an overall rise of all prices, or inflation. This in turn increased business expenses and thus decreased profit margins — thereby setting the stage for a contractionary economy that ushered in an era of higher unemployment. The equation was simple yet devastating: inflation plus unemployment equaled stagflation, which resulted in a weak economy.

As a result of stagflation and the overall lack of stimulus the US economy was facing, the US dollar began to fall sharply in value. The result of this, however, was more drastic than usual: since all oil transactions are denominated in US dollars, OPEC's realized profits were diminished, as the devaluation of the US dollar essentially devalued the revenues OPEC received. In order to compensate for the devalued US dollar, OPEC decided to further raise the price of oil. The result was what appeared to be an endless cycle: a rise in oil prices weakened the US economy, which in turn weakened the US dollar; due to the fact that oil transactions were and still are denominated in US dollars, though, the devaluation of the US dollar resulted in reduced realized revenues for OPEC - and hence they countered this by increasing oil prices.

Political conflicts continued in the Middle East, as the Yom Kippur War was followed by the Iranian Revolution. After a decade-long oil crisis, prices finally returned to more "normal" valuations in the 1980s, when US president Ronald Reagan introduced fiscal policies to alleviate the stagflation brought about by high oil prices. Reagan reduced taxes, thereby providing entrepreneurial stimulus that resulted in a revitalization of the US economy. Meanwhile, Federal Reserve chairman Paul Volcker tightened monetary supply by raising interest rates - and thus countering the dilemmas stemming from inflation.

Is it possible for an OPEC-inspired oil crisis to re-emerge? Statistically, the answer is no. The correlation between oil price and US GDP since 1980 is non-existent. This may result from the fact that oil prices are simply headed downwards; the advent of new oil drilling technologies has drastically reduced the cost of producing oil, which ensures that competition in the marketplace will drive the consumption price of oil downward as well.

Alternatively, it may also stem from varying monetary policies the US Federal Reserve has begun to employ with reaction to oil price changes. While Volcker employed a reactionary policy to oil prices under which interest rates were raised, Greenspan has chosen to do the opposite: he has cut interest rates, hoping to stimulate the economy and ward off and oil-induced maladies in the process. Essentially, Greenspan has operated under the belief that the inflation threat is minimal, and that loosening the money supply by slashing interest rates is the best way to ensure the economy remains in optimal condition even when oil prices are raised.

Ultimately, if the correlation between oil and GDP is a matter of the past, than Greenspan's policies should prove to be ideal, as they will allow for continued growth without the possibility of inflation. If Greenspan is incorrect, however, and a rise in oil prices does serve as a catalyst to inflation and a contractionary GDP, then the ensuing situation may be more problematic: lower interest rates and higher oil prices could lead to accelerated inflation, which in turn will bring about higher business costs and perhaps the same fatal quagmire that plagued the United States throughout the 1970s: stagflation.