On first glance there appeared to be few significant changes of note when looking at the currency-specific data in the latest BIS survey. But scratch beneath the surface and this data asks some important questions, says Galen Stops.

Looking at the data regarding the currencies themselves in the latest OTC FX turnover survey from the Bank for International Settlements (BIS), the first thing that becomes apparent is that the US dollar remains very much at the heart of the global financial system.

With an average of $5,819 billion changing hands each day, this currency was on one side of 88% of all trades when the survey was conducted in April 2019, very marginally higher than 2016.

There is, it seems, little in the data to suggest that there has been or will be any erosion in the dollar’s dominant position in the financial system. A lot has changed politically in America since the last BIS survey was conducted, however, and these changes may have significant ramifications for the future of the currency.

“The US previously offered access to its capital markets almost as a public good, as a utility. But increasingly it’s weaponising access to it,” observes Marc Chandler, managing partner and chief market strategist at Bannockburn Global Forex.

He points to the decision taken by the US government in early October to blacklist a slew of Chinese companies as evidence of this, pointing out that while previous sanctions were ostensibly issued on national security grounds, the US said that these were being imposed due to alleged human rights violations against Muslim minorities in China’s far-western region of Xinjiang.

“It seems like the bar keeps lowering in terms of what the US government is willing to cut people off from this utility for,” says Chandler. “And I think that this encourages people to look at alternatives within the financial system.”

Weaponising Markets

One recent example to back up this claim is the announcement made in September that Russia and Iran will transfer payments using an alternative system to the internationally recognised Swift money transfer network.

Instead, the two countries will use their own domestically developed financial messaging systems – Iran’s Sepam and Russia’s SPFS. This appears to be a conscious attempt to try and move away from the existing financial system network and infrastructure, of which the dollar is at the very centre.

Looking ahead, Chandler sees potential scenarios in which the US dollar could lose its current role as the global reserve currency. The first is that a better alternative might take its place, however, he says that one doesn’t exist right now and it’s not clear where it would come from.

“I’m told that there are better keyboards we could use than the one we use for computers today, there are designs that would reduce the distance that our fingers would have to move as we type, but we’re not going to adopt those designs because they’re not going to be that much better. Similarly, we would need to see a clearly superiour alternative to the US dollar, and I don’t think that exists right now,” explains Chandler.

The second scenario in which the dollar would lose its dominant role in financial markets, he adds, is if the US government decided to abdicate its role in the world economy.

“I think that the US is partly doing that right now through two channels. One is the practical side, weaponising access to the US market. Another side is this intellectual current which argues that being the reserve asset of the world is not really in the US interests and that it is being taken advantage of because other countries are boosting their economies, not by buying US goods but by buying our Treasuries,” says Chandler.

Ebrahim Rahbari, global head of FX analysis at Citi, takes a similar view, arguing that while a lack of viable alternative currencies to replace the dollar with means that it is unlikely to see its central role in financial markets change any time soon, in the longer-term it might decline as a percentage of overall currency trading.

“For now, yes, there is no candidate in sight that can rival the USD’s role anytime soon, however, that is different from the possibility for the dollar’s share to decline somewhat in future surveys. Over the medium term, that seems fairly likely, if only as the share of emerging markets grow (including some growth in EM cross-trades), while there are active efforts under way in several jurisdictions (notably Europe, Russia, China) to reduce reliance on the USD,” he says.

Divergence Within EM Currencies

Another significant data point in the latest BIS survey is that emerging market currency trading increased by about 4% to become 25% of the total FX market turnover, continuing a growth trend that was established in previous surveys.

This headline figure, however, masks the fact that the growth in EM currency trading was decidedly uneven. For example, the Korean won, Indian rupee and Indonesian rupiah all moved higher in the BIS global rankings, while the Mexican peso and the Turkish lira were among the currencies which dropped several places in the rankings.

Rahbari explains that the change in currency shares in the study is the outcome of shifts across products as well as currency specific factors, meaning that multiple overlapping factors are always likely to be involved in any changes in the global rankings.

He adds: “Where that’s relevant here for instance is that the observed shift from spot to forward and swaps in the FX market may have weighed on the shares of TRY (forwards) and MXN (swaps) where their relative shares are lower. In both cases, the move down the rankings also follows previous increases so the total standing is not out of line with previous historical patterns.

Plus the series shows a modest shift to ‘other’ currencies, which include some of the frontier currencies. But at least in the case of Turkey, lower liquidity and greater volatility in the last few years, and in particular periods of turbulence in currency markets, probably weighed on activity.”

When it comes to EM currencies, the RMB has been one of the big growth stories over the past 15 years. In the 2004 BIS survey, just $2 billion was traded on average per day. By 2013 this figure had jumped to $120 billion and in the subsequent 2016 survey it increased 82% to reach $202 billion, becoming the world’s eighth most actively traded currency and overtaking the Mexican peso as the most actively traded EM currency. Also in 2016 the International Monetary Fund (IMF) introduced the RMB into its Special Drawing Rights (SDR) basket, which was viewed by many as a significant symbolic step towards the further internationalisation of the currency and therefore a potentially positive factor for its growth.

Given this, and that China’s economy has continued to grow both in literal terms and in relevance to the global financial system, it is perhaps surprising that RMB did not continue in its upwards trajectory within the BIS global rankings. Yes, the latest survey showed that RMB activity increased by 40% in the past three years, with an average of $282 billion being traded each day, but the BIS itself notes that this increase is in line with aggregate market growth and that the RMB did not climb in the global rankings, as it has done in every past survey since it was included in 2004.

Mixed Messages

One senior economist based in Hong Kong says that they were surprised that RMB didn’t continue the growth trajectory of recent surveys, and pointed to a slowdown in offshore RMB trading as a reason for this change. They note that in the past much of the growth in RMB trading has been driven by offshore trading in CNH, but that since the last BIS survey the share of offshore trading of this currency relative to onshore has declined from 73% to 64%. The economist adds that there are a few factors which have contributed to subdued levels of CNH trading, such as liquidity shocks experienced in this market and some interventions by the People’s Bank of China (PBoC) in Hong Kong when it was concerned about CNH/CNY spreads and was trying to shake-off speculators.

Rahbari also sees multiple factors accounting for the relative slowdown in the growth of RMB trade.

“The most significant is that after several years where the policy to internationalise the RMB and increase the openness of China’s capital account, signals and policy measures in recent years have been more mixed. Indeed, on and off since 2015, China has tightened capital controls. In addition, growth in China overall has slowed, which should also spill over to some slowdown in FX trading, too,” he says.

Rahbari expects, however, RMB trading to pick up again going forward, commenting: “For now, I would expect subdued growth in the RMB’s FX share to continue, given continued capital controls and middling Chinese economic growth. However, that’s not a ‘new normal’ and very substantial growth in Chinese FX share can still result – the RMB share still far lag China’s role in other economic and financial markets and its very much up to policy authorities in China to accelerate the international role of the RMB. I suspect that even between now and the next survey, we’ll see some re-acceleration in the growth of the RMB share.”

RMB Growth Over-Hyped?

Chandler though, says he wasn’t surprised by the slowdown in RMB growth, declaring that the internationalisation of the currency was always an “over-hyped story”. He argues that what many people called “internationalisation” was really just the “sinofication” of Hong Kong, as more Chinese people in the territory traded RMB.

Chandler also cites some data points which explain why he wasn’t surprised by the BIS data. For example, he says that the number of new dim sum bonds — bonds issued outside of China but denominated in RMB rather than the local currency — sold in Hong Kong has declined by about 80%. In addition, Chandler suggests that the amount of trade that gets invoiced in RMB might have actually fallen since 2016 and that the number of RMB deposits in Hong Kong has also fallen.

Pointing out that the figures from the BIS survey and the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) data show that the RMB is still growing from a low base, he also claims that “investors aren’t beating down the door to buy China”.

Chandler continues: “I think that the key issue now is around the bond indexes. The Bloomberg Barclays Global Aggregate Index incorporated Chinese bonds this past April, but other indexes really haven’t done the same. And that’s important because we think about the cross border movement of capital, which gets reflected in the currency market, the bulk of it is not equity, the bulk of it is bonds.”

He says that while Chinese bonds should in theory be attractive to investors given their yield, firms are deterred from buying them for a myriad of reasons, such as the government control of the economy, the fact that the rules around taxation are not very clear and that while it is easy to get money into China now that regulations such as the Qualified Foreign Institutional Investor rules have been relaxed, it’s a different story when it comes to getting that money back out.

“So really, I’m not surprised by the renminbi data,” concludes Chandler.

HKD Trading Spikes 165%

Despite divergent growth patterns within the EM currency space, the expectation is clearly that this segment will continue to grow as an overall portion of the global FX market. One economist explains that this trend merely reflects the growing overall share and weight of EM economies within the world economy, and the fact that as financial markets in these EM currencies become more accessible to international investors then their currencies will naturally start to internationalise in response.

Despite this, the economist does point out that there are efforts in a number of these EM countries to actually move more trading activity onshore. Malaysia, the economist says, is an example where there seems to be a desire to move the hedging market onshore. Thus, it seems that the growth of individual currencies within the EM block is likely to be uneven, depending on the economic policies being pursued in these countries.

Another perhaps surprising point in the BIS data is that trading in Hong Kong dollar increased by a massive 165% in the 2019 survey compared to the 2016 one, with an average of $233 billion in this currency being traded every day in April of this year. Rather than being a significant indicator of any major trend upwards in HKD activity, however, most market sources seem to think that this spike was due to a number of market issues occuring at the time.

For example, one strategist notes that were was a widely reported attempt to break HKD’s peg to the US dollar. They add that many leveraged firms were bearish on Asia around April because of the trade war and the slowdown of China’s economy but they didn’t want to take USD exposure directly and they wanted to remain in the APAC region. As a result, the strategist says, these firms would typically go long on HKD and short everything else.

Additionally, one senior figure at a major bank in Asia attributes the heightened volume in HKD trading activity to the interest rate differentiate between the short-term Hong Kong Interbank Offered Rate (HIBOR) and the London Interbank Offered Rate (LIBOR) that opened up in April, which they say led to an increase in carry trade activity.

Questions, Questions…

Looking ahead, one ventures to predict that the currency data within the 2022 BIS survey will, broadly speaking, look rather similar to this one. The tectonic plates of currencies tend to move slowly, but when a shift does happen it can have a sizable impact on financial markets and the world economy.

The dollar will continue to dominate in terms of trading activity, but will political factors start to chip away at its position as the global reserve currency? Any increase or decrease in JPY trading activity will likely mirror the amount of FX trading taking place in Japan, but with Singapore and Hong Kong overtaking the country as an FX hub is a decline more likely? It’s hard to imagine that anyone in their right mind would predict anything but further growth for EM currencies, but as ever, this growth is likely to be uneven within this bloc and so then the question becomes: where will the pockets of increased activity occur? What will be the impact of Brexit on GBP trading? And can an increasingly fractious Europe manage to keep threats to the euro at bay?

The answer to all these questions may not become apparent in the next three years, but ultimately they are all ones that need to be answered, and hopefully, data can keep pointing us in the right direction to do so.

Galen Stops

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