BY definition, a major international currency is widely and actively traded in the foreign exchange (FX) market globally and used extensively among non-residents offshore. This chapter examines the renminbi (RMB) FX market that extends well beyond the still partially closed onshore RMB market.
In terms of global FX-turnover ranking, the RMB is rising rapidly, but at No 9 is still grossly underweight. The next chapter will show that Beijing has been tapping offshore RMB markets to promote the external use of the RMB, given its concerns about a more open capital account and the associated more volatile capital flows, with Hong Kong as the premier offshore RMB centre.
FX-market turnover is both a cause and a consequence of the more international RMB. By 2020, we believe that RMB daily turnover could increase eightfold to about US$1 trillion, which would place it among the world’s five most-traded currencies — after the yen (JPY) and ahead of the pound sterling (GBP). This projected rise in RMB FX trading is principally driven by China’s rising weight in world gross domestic product and trade, more flexible exchange rate policy and considerably more open capital account, which should give rise to larger and more volatile capital flows as well as an expanded international balance sheet of assets and liabilities.
To be meaningful globally, a currency must trade actively against most others in the FX market and across all trading zones and be used widely abroad for the likes of commerce, investment, positioning and hedging. If thinly traded, a currency is unlikely to be meaningful for even commercial settlements or invoicing, let alone for investment or as a reserve currency.
As measured by trading volume, FX is easily the biggest global financial market. For an international currency, its market operates onshore and offshore as well as across borders, linking to both commercial and financial transactions and involving a wide range of financial markets, from the bond, stock and money markets to their derivatives. According to the BIS 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity (BIS, 2013), global daily FX turnover reached US$5.3 trillion in 2013, dwarfing the stock market’s daily average of “only” US$220 billion.
Yet, in reality, FX-market liquidity is concentrated within only a few major currencies. This is mainly to avoid the major inefficiencies of trading more than a few currencies, along with market inertia and the strong positive externalities related to network effects in the currency market. A currency is widely used in part because everyone else uses it.
The US dollar (USD) is by far the dominant global currency, accounting for more than 40% of global FX turnover. When added to the euro (EUR) and JPY, this rises to 75% of the global FX turnover. The remainder of the aggregate FX turnover is divided among 60 other currencies, according to the BIS survey. The RMB accounts for a tiny 1% of global FX turnover. Therefore, currency traders call the USD a “vehicle” currency, since it is often cheaper and faster for the Mexican peso (MXN) and the Philippine peso (PHP), for instance, to exchange through two separate legs of USD/MXN and PHP/USD rather than for the two pesos to trade directly against each other.
The FX market currently has three tiers of currencies, with the USD at the top, then a small group of three to five currencies, and far below are about 60 other currencies. We designate the top two tiers as “global currencies” here. Some of the smaller currencies may be actively traded, but are not meaningful globally for our purposes. This three-tier structure in the global FX market has been broadly stable over the past three decades. As a baseline scenario, we expect the USD to continue to dominate over the next two decades. A multipolar-currency regime is possible by 2030, but most unlikely before 2020.
Is there scope for additional global currencies or is the FX market already too crowded? New international currencies offer potential benefits in terms of portfolio diversification, but managing the resulting risks may be too costly. Given the heavy concentration of
FX-market liquidity, the higher hedging costs of less-traded currencies could even outweigh the potential diversification gains, and as a result, traders may see diminishing returns (Ma and Villar, 2014).
Therefore, a more germane question is whether the RMB can achieve second-tier status by 2020, joining the EUR, JPY and GBP. A global portfolio can accommodate only so many currencies, typically weighted towards the few that are already widely used and actively traded. For the RMB to join those ranks, it would have to either share the same liquidity pool or displace one or more second-tier currencies. An expanded FX market could, of course, create room for additional global currencies.
Is the RMB then capable of capturing any such additional turnover? Assuming that rapid reform continues, it seems promising, based on its recent record. Between 2007 and 2013, the key emerging-market currencies’ share of global FX turnover rose from 12% to 17%. The RMB appears to have captured a significant portion of this gain. As discussed earlier, we estimate that RMB turnover globally at the end of 2014 had doubled from the April 2013 level of US$120 billion reported by the last BIS FX survey.
Reproduced with the permission of John Wiley & Sons
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