Currency depreciation:

Publication: ALM Gafoor Research

Provider: A L M Abdul Gafoor

June 22, 2009

Currency Depreciation:

Estimation and Applications

By

A.L.M. Abdul Gafoor

Appropriate Technology Foundation

Groningen, The NetherlandsIntroduction

In another work (Gafoor, 1999) we looked at inflation and its measurement in some
detail. In it we also developed a new method appropriate for the measurement of
inflation on capital, and we used it to compensate capital erosion due to inflation in
lending and borrowing transactions as well as in investment and finance. It was
necessary to develop a new measure because it was found that the existing measures of
inflation (such as the consumer price index) were not appropriate for the measurement of
inflation on capital.

In another work on money (Gafoor, 2001), the history of money was traced from
antiquity to the present and its transformation from gold coins and gold-backed paper
currency to the present fiduciary currency, whose value is dependent on market forces.
Currency depreciation is defined as the value depreciation of currency relative to gold;
that is, how much less gold a given amount of the currency would buy from one point in
time to another point in time. For example, if 1000 units of currency bought one gram of
fine gold last year and 1100 units of currency were needed this year to buy the same
amount of the same quality of gold, then the currency has depreciated by 100 units during
the year. This is also the magnitude of the value erosion of capital due to inflation during
the year, and it may also be called the inflation on capital. Consequently, the new
measure (or index) developed to measure inflation on capital is also the same as currency
depreciation.

This measure is based on the market price of gold. Very briefly defined, the price of gold
for the current week is the average open market price of gold in the local (meaning
national) market, for the past 13 consecutive weeks. Thus it is the 13-week moving (or
rolling) average price.

In this essay we propose to demonstrate how this measure (or index) is computed using
real-life data. The procedure explained below could then be used to compute the
magnitude of the value erosion of capital due to inflation in any given country in any
given time period. Data

The data necessary for the exercise is the daily price of gold (of a specified quality and
quantity) in terms of the national currency at the local (meaning national) open market,
collected and collated consistently and continuously by an independent body (or
authority) using predetermined and documented transparent procedures and a single
national price determined and reported daily, and published in the official and public
media. Each of the adjectives and adverbs used in the last sentence are of high
importance for the success of the procedure and the systems that use the results – daily
price, specified quality, local open market, consistently and continuously, predetermined
and documented transparent procedures, single national price, daily reporting, public
media, etc. This is to ensure that no room is left for any manipulation of the data or the
results before, during or after their collection, collation, computing and reporting. Once
published in the media the raw data is in the public domain, and any manipulation
afterwards can be checked and challenged.

In practice the price can be defined as “the price of one ounce (or gram) of fine gold in
the national currency in the local open market”. The competent body could be the
central bank of the country, the national statistics bureau or any other competent public or
private organisation. It is important that the methods of collection, collation and
computation are well documented and published and that the procedures are transparent.
It is also important that the price data are collected and collated each working day and the
single realised market price computed, recorded and published the very following
day.Data collection and price determination

The competent body mentioned earlier is entrusted with the data collection, collation and
estimation process. These are statistical procedures and we have to leave it to the
competent authority to decide on the parameters and to the statisticians of the authority to
devise a sample survey plan. The parameters include the required accuracy, coverage,
time frame and cost considerations. This exercise will result in the publication of a single
national price of gold that was realised in the market during the previous day.

For the purpose of this essay we will describe the raw data we have obtained and, in the
next section, describe the procedures for computing the 13-week rolling average price
that will be used as the gold price for the next (14th) week. This may be called the
operative price for the week since it will be the price used in all relevant lending and
borrowing operations during the current week.

The data used in this essay to illustrate the methodology is the daily gold price in
Amsterdam, the Netherlands, as reported in Edelmetalen Amsterdam (Precious Metals,
Amsterdam), a publication of the Hollandsche Bank-Unie (Dutch Bank Union). The data
relates to January 1999 to July 2000, and is given in Dutch Guilders per gram. See Table
1. The first column gives the week number and columns 2 to 6 the prices as obtained in
the workdays (Monday to Friday) of the week. N/A stands for “not available”, most
probably the day having been a holiday and the market closed. Column 7 gives the
weekly average price. The next column gives the 13-week rolling average, and the last
column the weekly operative price. Figure 1 gives a plot of the weekly averages prices
and the 13-week average prices. Note the volatility of the weekly averages and the
smooth movement of the 13-week averages.Computations

The daily price data is arranged in weekly blocks, Table 1. Generally a week consists of
five working days but in some weeks one or more holidays may occur making it a 4- or
3-workday week. Therefore the average daily price for the week is obtained by dividing
the total in each block by the number of working days in that week (data points in that
block). We may call this the weekly average price or the average price for the week.

Next, the 13-weeks average price is obtained by computing the average of the weekly
average prices of 13 consecutive weeks. This will be the operative price for the next
consecutive week – the 14th week. This price will be used for all transactions during the
14th week.

The operative price for the 15th week is obtained as follows. During the 14th week, enter
the daily price for each day as it is published. At the end of the week, the weekly average
for the 14th week is computed and recorded. Now, add the 14th week average price to
the total of the 13 consecutive preceding weekly averages computed earlier, and drop
(subtract) the 1st week’s average price from the new total. This gives the total of the 13
consecutive weeks immediately preceding the 15th week (i.e. 2nd to 14th weeks). Divide
the total by 13 to obtain the 13-weeks average price, and this will be the operative price
for the 15th week. Similarly, the operative price for the 16th week is obtained by
computing the average of the 13 weeks immediately preceding the 16th week (i.e. 3rd to
15th weeks).Operative price and its operation

At this point we need to explain what is meant by operative price (for the week).
Keeping it short (refer to Gafoor, 1999 for details), though deposits and loans of a
duration longer than 13 weeks (3 months) will be accepted and granted, respectively, in
terms of the local currency the accounts will be kept in terms of gold units – say, so many
grams of fine gold. When the depositor wishes to withdraw it the same amount as was
recorded in terms of gold units will be returned to him, even though he may receive more
(than he deposited) in terms of currency units. In theory, this is exactly as if he deposited
a certain amount of gold at the bank and later retrieved the same without any loss or gain
– absolutely riba-free. In the case of loans, the borrower is obliged to return the same
amount of gold units as was recorded in the books when he borrowed, but this amount of
gold may now cost more in terms of currency and consequently he may have to pay more
than he received in terms of currency.[1] The conversion factor used – to convert
currency units to gold units and vice versa – is the operative price of gold. If the week’s
operative price is denoted as “wop” (i.e. say, 1 gram of gold is wop units of the local
currency), then when 1000 units of local currency is deposited it will be recorded as
1000/wop units of gold.

In order to fix the idea firmly, let us take an example. Suppose a deposit of 1000 units of
currency was made in a certain week, and the wop in that week was 50. Then this is
equivalent to (1000/50 =) 20 units of gold. Say, the depositor returned after 40 weeks
asked for his deposit, and the wop in that week was 55. His deposit in the bank’s records
is still 20 units of gold, but since the wop this week is 55 he will be given (20x55 =) 1100
units of currency. The extra 100 he receives is compensation for the value loss his capital
suffered during the 40 weeks it was with the bank.

This means that he could go out to the open market and buy the same amount of gold
today that he was able to buy 40 weeks ago – that his depositing the money with the bank
(or lending it) has not eroded the purchasing power of his money in terms of gold, a basic
metal with an intrinsic value, which used to be the universal currency from antiquity till
very recent times. The fiat money (paper currency) can still perform the functions of unit
of account and medium of exchange, but the function of store of wealth, which it had lost
in recent times, has now been restored to it through this devise. Thus this method builds
a bridge between the two extremes of going back to the gold coins as currency and the
inevitable collapse of the monetary system if the present state of the un-anchored fiat
currency (at the mercy of currency traders, government printing and bank credit creation)
is allowed to continue. It will retain the convenience of the paper currency, which is
more convenient to carry than bags of gold, on account of which the paper currency was
originally invented, without losing the currency’s function as a store of wealth.

In private person-to-person lending / borrowing transactions too the same method could
be used. Again, the idea is that the same amount of gold is borrowed and returned
without any addition or subtraction – an absolutely riba-free transaction as it would have
been in the time of the Prophet (pbuh) and until recently. Any additional amount the
lender may receive in terms of paper currency is the loss his capital suffered while in the
hands of the borrower due to currency depreciation. In this method of transaction the
lender does not suffer real loss of value in his capital, nor does the borrower gain any
advantage due to currency depreciation. Hence this additional amount is definitely not
riba, but an accommodation necessary to adjust to the peculiar circumstance of our time.
Hopefully this is a temporary step until such time as better counsel prevails and paper
currency is again pegged to solid gold. Perhaps this effort will help bring to a halt the
present slide towards chaos and initiate the journey back towards gold-based paper
currency.

(This method is equally applicable when the currency appreciates – a phenomenon rarely
seen in recent times – and in that case too the lender will not gain any advantage and the
borrower will not lose.)Applications

In conventional banking too currency depreciation is taken into account, but tacitly, and it
is included in the all-inclusive interest rate as compensation for value loss of capital due
to inflation. In the case of deposits it is always seen to that the interest rate is set higher
than the inflation rate and therefore the real interest rate is always positive – or seen to be
positive. However, there are three difficulties in this concept; two are common to
everybody and one is specific to the Muslims.
1. The measure of inflation used (or assumed to be used) is inappropriate for
measuring inflation on capital. See Gafoor (1999) for details.

2. An estimation of inflation is made by the bank right at the beginning of the

transaction (deposit or loan) and is effective (generally) for the total duration of the
deposit or loan – three months, one year, three years or more. But there are no measures
of inflation that could predict inflation of the future with any accuracy – the further the
future the wider off the mark the prediction.

Taking the above two difficulties together, the inflation estimation is both inappropriate
and widely off the mark. In order to be on the safe side the bank always uses the lowest
estimate (whatever the measure used) in setting the deposit rate, and the highest estimate
in setting the loan rate. Since in most of the transactions the bank is an overwhelmingly
powerful party, what the bank says goes. Hence both the above difficulties are used in
favour of the bank and to the disadvantage of the customer.

3. Interest has always been considered a single entity, both in theory and practice.
But in reality, several factors are taken into consideration by the bank in fixing this single
entity. For example, the deposit interest consists of both compensation for inflation and
real interest (or usury, riba). (And the loan interest consists of these as well as the
operational costs of the bank, its profit, etc.)[2] This has consequences for a
conscientious Muslim. For when he rejects interest on his deposit considering all of it as
riba he also throws away the compensation for inflation part. The latter is his due since
his capital lost part of its value through no fault of his. But he has no option since he
cannot separate one from the other.

In the method presented in the foregoing paragraphs, we have provided a theory and
procedure by which all the above three difficulties are overcome – a measure of inflation
appropriate to the measurement of inflation on capital; a procedure that estimates and
compensates the realised (and therefore accurate) loss of value suffered by capital,
thereby protecting both the lender and the borrower (and this both transparently and
equitably); and a method to separate riba from interest and thereby help Muslims to keep
away from riba without suffering loss to their capital. The last helps those Muslims who
live in both Muslim and non-Muslim countries, where fixed deposits in conventional
banks is the only option to keep their monetary wealth safe, to keep away from riba (by
throwing away the riba component) and still protect their capital from any value loss.[3]

In short we have now come into possession of a method and procedure that helps us keep
capital counted in currency units to be coupled to gold so that the real value of capital is
not eroded by inflation (due to currency depreciation). This method can be applied to
protect capital in all kinds of situations, such as in bank deposits and bank loans,
investment and finance, and in person-to-person lending/borrowing.References:

1. Gafoor, A.L.M. Abdul, Interest-free Commercial Banking. Groningen, the

Netherlands: Apptec Publications, 1995. Revised edition, 2002. 98p. (Reprinted in
Malaysia by A.S. Noordeen, Kuala Lumpur.)
2. -----------, Commercial Banking in the presence of Inflation. Groningen, the
Netherlands: Apptec Publications, 1999. 134p. (Reprinted in Malaysia by A.S.
Noordeen, Kuala Lumpur.)

3. -----------, Money, Gold and Inflation: Some history and observations. 2002.
Unpublished. Available from the author on request. E-mail: abdul@bart.nl.

4. -----------, Interest, Usury, Riba, and the Operational Costs of a Bank. Groningen, the
Netherlands: Apptec Publications, 2004. 80p.

© A.L.M. Abdul Gafoor 2004.

30 November 2004.