They're illiquid, subject to government interference, and with no LIBOR-style reference source for pricing. So what's the appeal of non-convertible currencies?
In a word: China.
There's more trading in non-convertible emerging currencies than you might think. Last year's 2010 triennial central bank report1 estimated trading in RMB outside its home market at US$22bn (or, if you're thinking ahead to a post-dollar reserve, CNY144bn). A previous underestimate of Indian rupee trading in London and New York, as well as Singapore, delivered a surprise $17bn for that currency for the year.
A paper2 published in March by the Bank for International Settlements (BIS) on FX trading in emerging currencies pointed out that similar dollar amounts in currency turnovers belie "ratios that differ by an order of magnitude. Thus, the RMB trades less than China's trade and income would suggest, while the rupee trades more than India's trade and income would seem to warrant."
Trading in the Brazilian real, the Korean won and the Russian rouble occurs mostly in their domestic markets. It gets interesting when it goes overseas because restrictions on international currencies split offshore (via non-deliverable forwards - NDFs) and onshore trading, which can impair liquidity but create trade-encouraging opportunities for arbitrage.
In embracing its offshore RMB market, China is pursuing the model developed by Korea, which has both a lively domestic market, settled via CLS and with volumes that approximate to the Swiss franc, and an active offshore NDF market. Korea manages its currency by separating the onshore, regulated market from the external market.
In contrast, other governments have responded to offshore currency markets with what one currency specialist, who works at as an international financial regulator and preferred not to be named, describes as the five stages of grief. "They've done denial. Now they're bargaining," he says. "They reason that there's less risk in an NDF than in a swap because there is no exchange of principal. In the technical sense, they're less risky."
NDFs are, of course, both more and less risky in other respects. For one, they're settled by CLS. "The biggest issue for the more esoteric currencies is that the NDF parties have to go to a reference source - one that both sides think is credible and reliably available - to find a price and then settle the difference," says CLS communications director Jonathan Butterfield.
"From an operational perspective our settlement service is a straight-through process, but from a trading perspective the willingness to trade a currency as an NDF will be influenced by the credibility of the reference source. Most traders would want the equivalent of LIBOR or a central bank rate, but for thinly traded currencies that is more problematic."
Opacity, volatility, convertibility
Moreover, concern lingers about the potential risks associated with NDFs and, in India's case, because of what it sees as linkages between onshore and offshore NDF markets. A financial stability report3 published by the Reserve Bank of India (RBI) in December, expressed unease over capital flows "dominated by volatile components", estimating that 52% of the daily turnover of NDFs and swaps were traded offshore.
According to the RBI report, the fact that most participants in the NDF markets tend to be speculative hedge funds and multinationals adds to the risk. Because these markets are opaque, they offer no early warning on large one-way bets.
"The opacity is greater when the market is outside the country," says Jayanth R Varma, a professor of finance at the Indian Institute of Management in Ahmedabad. He points to central banks that have mitigated the problem by conducting limited trading activities in these markets themselves "since the best way to get a view of these markets is to trade in them".
It's difficult to gauge the significance of China's offshore currency experiment but Li-Gang Liu, head of China economics at ANZ, reckons that if the experiment is successful in Hong Kong, it could happen next in Taiwan or one of the Asian countries. "It's really hinged on Chinese liberalisation. But you won't see fast progress on renminbi internationalisation," he says. "It will be a gradual process, and it will depend on whether China can manage capital inflows."
Yet as Lombard Street Research's China specialist Diana Choyleva pointed out in a recent research note, if China allows free capital movement in the context of excess savings and low returns, it will lead to capital outflows and a weaker currency. Despite the government's resistance to substantial appreciation, she says in the note, "the investment community appears convinced that over the next three to five years the yuan is a one-way bet."
Yet open up the currency, and it could well depreciate. Choyleva argues that Beijing has reached the end of the road of its export-led growth model "where the state uses the banks as ATMs". Nor, if China is to emerge with a currency to rival the dollar, can it keep the capital account closed.
Mark Williams, senior China economist at Capital Economics, agrees. The government, he says, has tried to balance two competing policy goals. On the one hand, it wants to internationalise the currency; on the other, it wants to control the value of the currency, to avoid the destabilising effect of capital flows. "One of those policy goals has to give," he says. "At the moment, there is a big emphasis on exchange-rate stability. If capital flows freely, the renminbi will appreciate. The government won't allow that until it's ready."
As The Economist pointed out in January4, if foreigners are to store their wealth in RMB, they will need financial instruments that are safe, stable and easily sold. Dim sum makes for a tasty appetiser, it said, but the main feast of China's financial assets is onshore and off-limits.
The Chinese central bank's goal is, and has long been, full convertibility. According to Williams, convertibility is at least a decade away because China needs a mature and stable financial system before it allows cross-border capital flows. When it happens, the Chinese government - and the rest of the region and the world - will just have to learn to live with volatility.
A full exchange would take a sophisticated market, agrees Liu, and that will be a gradual process. But China doesn't have much time: it has already announced that it plans to make Shanghai an international financial centre.
"There is no question of whether the renminbi capital account will be liberalised. It will." Hong Kong financial services and treasury secretary KC Chan told the China Economic Development Forum in March. "The only question is when." He indicated that Chinese controls on capital inflows were merely a temporary expedient en route to full convertbility.
The worry point
In fact, since the launch of the RMB-denominated so-called 'dim sum' bonds in Hong Kong earlier this year, forecasts for full convertibility of the Chinese currency have reached nostradamic proportions. There are currently CNY 74bn outstanding dim sum bonds in the territory, forecast to increase to CNY 180bn by the end of the year. There's talk of a deliverable currency swap market evolving to meet the demand from issuers to keep their RMB proceeds offshore and swap into other currencies.
Even short of convertibility, partial RMB liberalisation - with the Chinese government allowing the use of RMB in trade - is the point at which we should begin to worry, suggests Monish Mahurkar, head of local currency capital markets at the Asian Development Bank. "As RMB trade related payment flows increase, the ability to convert into and from RMB to other currencies will become critical, else RMB flows forced to remain offshore will have a significant market distorting effect once these become large enough to matter," Mahurkar says.
Large enough they soon will be. Trade settled in the Chinese currency was RMB101bn in December, up RMB10 from July.
If the focus to date has been on how internationalisation of the RMB will affect regional currencies, Guosheng Wang, general manager of global trading services at Bank of China, claims it is up to these countries to push for RMB settlement. It's in their interests, he says, because it mitigates exchange rate risk of international currencies, especially the US dollar.
It's equally up to Asian countries, especially China's major trade partners, to improve currency cooperation and the acceptance of RMB in their own markets. "Only this cooperation can in the long run benefit all the countries in Asia and help to build a stable, healthy and open financial market," says Wang.
The hype cycle
Other non-convertible currencies - even that other BRIC non-convertible, the Brazilian real - are way behind. After initial speculation about progress towards convertibility, the Brazilian government in October acted to curb a currency rally caused by so-called "hot money". Mexico provides a geographically approximate lesson in the volatility that follows convertibility.
Vitoria Saddi, a partner at São Paulo-based firm SM Managed Futures, claims convertibility is as much about politics as economics. "A currency is the mirror image of the country," she says. "There's a lot to be done in Brazil both in politics and economics. If you travel anywhere with the real and try to exchange it - good luck. Even the Mexican peso is only convertible within NAFTA."
Saddi adds: "Money talks. If you're a rich country, you will have political clout, as China has. In Brazil, poverty and inequality are worse than in China, and convertibility and per capita income are correlated. But perhaps a local is always more pessimistic than an observer from abroad."
Given China's size, Asian countries will look to the renminbi as a reference for their own currencies. But it won't just be regional currencies. There's also significant hype around the potential for their RMB to become tomorrow's reserve currency. No-one really doubts that it will- but not tomorrow.
The hype cycle started with a statement on the Chinese central bank's website in 2009 claiming that it was going to replace the US dollar as the reserve currency. Then Peter Redward, head of emerging Asia research at Barclays, last October claimed that Hong Kong would likely ditch its currency peg to the US within two years and instead link to the RMB, citing then-recent volatility.
Redward declined to update his forecast but few now think the move to make the RMB the reserve currency will happen sooner rather than later. The development is a given; the timing isn't.
Mahurkar reckons that the replacement of the dollar as a reserve currency is "logical" as trade flows in the RMB lead to eventual convertibility. "This will also be coincident with the increasing weight of China in the world economy," he says. "It's no different from the way the dollar, yen and euro became reserve currencies over the course of the 20th century as these economies came to represent substantial shares of the world economy."
The upshot, he says, is that regional currencies "will eventually trade more actively versus the RMB just as they do versus the euro and yen today, in addition to their primary trading versus the dollar".
So it's not time to get the flags out yet. Still, the RMB is a more likely prospect than the rupee as a future reserve currency. Even with full convertibility, says Varma, the Indian rupee won't become a worthwhile reserve until India achieves per capita income not much lower than China's.
"The rupee could become convertible before the yuan, but the yuan could get to become a major reserve currency before the rupee," he says. "China sees RMB as an international currency at some point in the possibly remote future and is preparing for this in ways that do not hurt it too much today. Unfortunately, India is not thinking that far into the future and is unable to see value in creating markets that may be a nuisance today but could bring big benefits in the next decade."