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This is currently, a gedanken experiment, but may well form the basis of a whitepaper - or better still, an actual project.

I am trying to come up with a practical way of creating a "currency index/basket" (of sorts) between a set of countries who want to form some kind of (geo?)political alliance, but currently, have their own currencies.

The idea is that if a freely convertible currency exists (ignore who "controls" the currency - for the purposes of this thought experiment), then the countries in the "allowed set" can freely interchange between each others currencies - without having to go through the Dollar, EUR, Reminbi or other external currency first.

The thinking is very much along the lines of the Euro (although the constituent countries need not be restricted to the same geographic zone in my case).

So, here are the salient points:

  1. A set of independent sovereign states exist, and they would like to increase trading amongst themselves
  2. Currently intra-set trading involves triangulation involving one of the majors.
  3. Wish to create an index that is effectively a weighted index of the currencies within the aforementioned set
  4. The index should be pragmatic, and ideally take into account inputs that affect people on the ground (i.e. cost of a basket of household items, factory inputs, market price of any natural resource that forms a portion of GDP revenue for the country etc. - rather than things like M1,M2 and M3)
  5. The index should be something that can be calculated on a daily basis - so the value can be set at the beginning of the day (akin to London metals price fixing - or indeed the fixing of LIBOR rates at the beginning of the day)

My questions are this:

  1. What would be suitable inputs to capture (on a daily basis)?
  2. How can these inputs be weighted to create the currency index? (i.e. suitable methodology etc).
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  • $\begingroup$ You build a currency index by picking weights, and then it is trivial to calculate the basket value. Anybody can create a basket, but the problem is getting people to use it. Unless you get “theory heavy”, you are not going to get any idea why anyone would use the currency. $\endgroup$ – Brian Romanchuk Feb 19 at 12:49
  • $\begingroup$ @BrianRomanchuk putting the "who would use it?" question aside for a moment - what would be suitable inputs (or proxies) for i). GDP components ii). inflationary pressures (anything else I've missed)? $\endgroup$ – Homunculus Reticulli Feb 19 at 15:50
  • $\begingroup$ So long as the weighting is based on economic data, it would change exceedingly slowly when compared to intraday currency values. The usual suspects would either be GDP or magnitudes of imports/exports. However, you accomplish nothing with an index - you need a tradeable basket. The weighting has to reflect how the basket units can be invested in the underlying currencies. So things like depth of financial markets probably matters more. $\endgroup$ – Brian Romanchuk Feb 19 at 19:08
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There is an economic literature on optimal currency areas. However, that is related to the adoption of a single currency.

As described in the question, a basket is just a new asset that is a weighted allocation to underlying currencies.

Once the weightings are fixed, the fair value of the basket is the weighted value of the component currencies, which can be updated in real time.

The only way that this basket changes anything in the real economy is that entities are willing to hold it and trade it.

The issue is straightforward: people and firms want their local currencies, not the basket. What they want is to translate the foreign currency to theirs.

Banks can offer quotes for any currency pair. It is only in the worst case that the quotes would have a bid/ask that is as wide as doing a pair of transactions versus a major currency (often USD, EUR). The only way a basket can improve matters is to have a tighter bid/offer versus the national currencies than they have versus the major currencies. How plausible is that outcome?

The weighting could be done in any number of ways, but the basket has to meet the constraint that people want to own it. The weighting has to reflect the ability to buy short-term financial assets in the underlying currencies. Realistically, that determination has to be done by the entities managing the basket.

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