CFM7014 - Understanding foreign exchange: exchange rates

The gold standard

Concern about exchange rates is a relatively new phenomenon in the history of trade and commerce. From classical antiquity, precious metals - gold and silver - provided a common medium of exchange throughout Europe and the eastern Mediterranean. So, for example, a 14th- century English merchant selling wool to Flanders would exchange the wool for a quantity of gold or silver coins. If he wanted to know how much the unfamiliar coins were worth in terms of English sovereigns, he could weigh the coins and assay the purity of the metal to determine what weight of pure gold or silver they represented. Although there were a bewildering variety of coins in circulation in various parts of Europe, money changers could quote fixed rates of exchange between them.

From the late 14th century, Italian bankers began to issue paper notes in lieu of gold or silver, so that merchants did not have to carry trunk-loads of coins around. By the 18th century, paper money had come into widespread use. But its value was still tied to precious metals - each note was theoretically redeemable by the government concerned for a set weight of gold or silver. As this amount changed only infrequently, traders rarely had to worry about foreign exchange fluctuations affecting their profits.

Up to the First World War and beyond, the value of all major currencies was fixed in terms of the amount of gold for which each could be exchanged - this was the gold standard, adopted by Britain in 1840. This meant that the value of the major currencies compared to each other were also essentially fixed. Exchange differences were not a common item in traders' accounts. For this reason, the early development of case law on the taxation of trading profits makes almost no reference to how exchange differences should be taxed.

The gold standard collapsed in the world recession following the First World War. Many countries tried to stimulate domestic demand by devaluing their currencies, leading to retaliatory action by other countries. Partly because of the damaging effects of such devaluations, an attempt was made in 1944 to return to a system of fixed exchange rates. Representatives of 44 countries met at a US resort called Bretton Woods to design such a system.

What came out of the Bretton Woods meeting was a partially fixed exchange rate keyed to the US dollar. An exchange rate for each participating currency (including sterling) against the dollar was agreed, with only minimal fluctuations being allowed. The dollar itself was pegged to gold. Stability was maintained by central banks intervening in foreign exchange markets to buy weak currencies and hence increase demand. An institution, the International Monetary Fund, was set up to lend money to governments to help them do this. Occasional devaluations and revaluations were allowed if a country's economic position changed substantially.

The Bretton Woods system had to be abandoned in 1972 because of pressures on the dollar, caused partly by the USA's huge balance of payments deficit following the Vietnam War and partly by rising oil prices.

A further system of partially fixed exchange rates was introduced in Europe in 1979, in order to encourage closer economic union. This was the Exchange Rate Mechanism, or ERM. A central rate of exchange was fixed against the European Currency Unit, or ecu. The ecu was not a real currency, but was calculated from a weighted average of all currencies in the European Union.

By 1992, divergent economic performance among EU countries was putting the ERM under severe pressure. As a result, the UK and Italy left the system, while currencies remaining in the ERM were allowed to fluctuate by up to 15% either side of the central rate.

Nevertheless, progress towards closer monetary union continued to be made and at the beginning of 1999, the euro was introduced. The currencies of 12 'eurozone' countries - Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain - were tied to the euro, so that from 1 January 1999 onwards, they ceased to fluctuate against each other. From 1 January 2002, the euro became the national currency of the countries concerned.

There is more information about the euro, including answers to tax-related questions which businesses frequently ask, on the HM Revenue and Customs website, at www.hmrc.gov.uk/euro.