Use of currencies In international trade

by Marc Auboin, Counsellor

•  3 basic realities and 2 questions

–  Trade finance: systemic to trade. Little trade paid cash - 70-80% of world trade relies on trade credit/guarantees.

–  Despite its safety (0.2% of default, ICC), trade finance hurt by financial crises, and in turn can hurt trade. Most trade finance is short-term (90-120 days). Pricing depends on IB rates, a bit on regulation.

–  Liquidity crisis can impact the availability of currency for international trade. If inter-bank market dries up in the Euro-zone or the USA, access to currencies become scarcer and more expensive. USD problem during the 2008-09, required the Fed to strike 14 swaps agreements with central banks from partner countries.

–  Question 1: The dominance of the USD and the EUR: to what extent?

–  Question 2: Are there any credible alternative; when?

–  Mapping of international trade

3

Selected intra- and inter-regional merchandise trade, 2010 (Billion dollars and percentage in world trade)

$3998 billion 26.9%

$2464 billion

16.6%

$956 billion 6.4%

Europe ó Asia $1332 billion

9% $148 billion 1.0 %

$62.5 billion 0.4 %

$89.1 billion 0.6 %

$109.1 billion 0.7%

Africa ó Europe

$360 billion 2.4%

$1214 billion 8.2%

: regional intra-trade

CIS ó Europe $488 billion

3.3%

Middle EastóAsia $669 billion

4.5%

North America ó Europe $746 billion

5.0%

South America ó North America

$303 billion 2.0%

Asia ó North America

4

Figure 1.2: Intra-regional merchandise trade, 2010

Commonwealth of Independent States

Africa

12.3%

19%

Asia

52.6%

Europe

71.0%* Middle East 10%

26%

48.7%

X%

Extra trade share

Intra trade share

Legend

* 27.9% for Europe excluding intra-EU trade

North America

South and Central America

USD dollar remains dominant international currency, by all standards, for example the main payment currency and the main international reserve currency. The event of the euro created a de facto duopoly

Facts and figures

Facts and Figures (foreign exchange markets – bis/hsbc fig.)

•  Inertia; liquidity; scarcity of currencies •  Inertia

The USD dollar is dominant in international trade – it exceeds not only the share of the US in international trade (both exports and imports) and that of its trading partners within NAFTA. The USD dollar is used widely for invoicing in the Asia-Pacific region, the fastest growing region for international trade. It is also widely used in the LATAM region and in commodities markets. Krugman explained that inertia in currency use played a role. The more established, the more difficult for user to shift to other currencies: there are clearly lower transaction costs in using widely available and liquid assets, economies of scales (higher transactions means lower spreads in forex markets). Such self-reinforcing pattern amplifies the inertia phenomenon – makes it difficult to displace a well-established currencies.

There is an incentive to use only one invoicing currency to maintain lower international prices

and competitiveness. The currency of reference is chosen according to the "thick market externality" principle, whereby the transaction costs of using a particular currency in the market are reduced with market size. Therefore, the currencies of countries with large trading power, high levels of openness and substantial bilateral trade flows are more likely to be chosen.

Factors explaining USD and euro prominence as a invoicing currency

•  Inertia; liquidity; scarcity of currencies

•  Liquidity The inertia is increased by the regular supply of dollar by the US through its balance of

payment deficit – dollar balances are regularly feed by the deficit – only once since 1980, US CA was in surplus

Factors explaining USD and euro prominence as a invoicing currency (2)

Source: IMF

•  Inertia; liquidity; scarcity of currencies

•  Liquidity Current Account deficit increase the volume of dollars available for cash transactions (3/4

of $100 bills and ½ of $50 bills are held abroad (60% for all bills) (Goldberg 2012). Dollar bond markets are supported by the issuance of $-denominated debt – which

account for up to 40% of bond holdings; the $ is also the prime currency of issuance for corporates in Asia and the Pacific rim, LATAM and the Middle-East.

According to the IMF, the largest share of international reserves is also denominated in $ (60%). Another factor in favour of $-denomination of trade creating some inertia is the large number of countries having a currency explicitly or implicitly pegged to the USD (some 90 in the world) – notwithstanding dollarization. All in all, $-use is supported by a strong economy, producing little inflation, stable returns on investment for non-residents and providing liquid currency markets.

Factors explaining USD and euro prominence as a invoicing currency (2)

•  Inertia; liquidity; scarcity of currencies •  Currency scarcity

The number of international currencies that have the characteristics of reserve of value and means of payment, offering stability and liquidity, and substitutability, globally, are scarce. The creation of the euro has certainly increased the hierarchy between currencies with respect to these standards.

Factors explaining USD and euro prominence as a invoicing currency (3)

Table 1.1 Currency Distribution in Foreign Exchange Transactions

Currency   2001   2004   2007   2011            US  dollar   89.9   88.0   85.6   84.9  euro   37.9   37.4   37.0   39.1  Japanese  yen   23.5   20.8   17.2   19.0  Pound  Sterling   13.0   16.5   14.9   12.9  Australian  dollar   4.3   6.0   6.6   7.6  Swiss  Franc   6.0   6.0   6.8   6.4  Other  currencies   25.4   25.3   31.9   30.1  

Source: Bank of International Settlement (BIS), Triennal Bank Survey, 2010 Notes: Since two currencies are involved in every transaction, the sum of percentage share of individual currencies equals 200%.

•  Inertia; liquidity; scarcity of currencies

•  Substituability

Goldberg and Tille (2008) explain the “coalescing” effect whereby exporters adopt a currency for invoicing based on the competitors attitude. If the goods of two exporters from different countries are close substitutes, competitors will tend to opt for the same currency to limit the fluctuations their product price relative to that of competing goods.

It follows that “exporters in industries where products are close substitutes make little use of

their currencies unless they are from the US” (Goldberg, 2009) – likewise for exporters from countries with a volatile exchange rate. Transaction size matter also, as well as the bargaining power between the exporter and the importer.

Factors explaining USD and euro prominence as a invoicing currency (4)

•  Recent developments: scarcity, volatility of USD •  Currency scarcity

USD dollar availability has been an issue during the financial crisis of 2008-09, with money market rates roofing up at the end of 2008, and liquidity being scarce. Refinancing needs of US$ debts by non-US banks (in particular European) have put pressure on the US dollar market as well. In emerging markets, $ has proved scarce for traders – resulting in US Fed to supply $ by swap agreements to foreign central banks having insufficient reserves. Other countries with large international reserves either set aside $ for trade (South Korea) or allowed direct discounting of trade bills at the central banks against currency.

•  Volatility and regional integration

The volatility of currencies against the $, of the $ itself against a number of large currencies, and the increasing share of intra-trade in the Asian region resulted in a demand for local currency invoicing, notably to reduce the effects of such fluctuations on intra-regional trade. In a move similar to that of European countries in the early 1970’s, Members of the ASEAN decided in the context of the Asian Financial Crisis to promoting swap arrangements between central banks and the pooling of reserves to fight currency speculation by providing short-term liquidity assistance (bilateral swap and repurchase agreements – using USD, yen and other currencies – repayment possible using local currency. Since then, the CMI has been considerably expanded (into the CMIM in 2009-10), and resources available now reached $240 billion.

Regional co-operation and local currency financing: a demand for it

•  Recent developments: scarcity, volatility of USD •  Local currency pricing and local currency financing

Local currency financing and pricing have many advantages in a commercially-integrated zone. As explained by Corsetti and Pesenti (2005) the currency of invoicing has an influence on the way in which macroeconomic shocks are transmitted, with exporters able to price in their own currencies being less subject to exchange rates fluctuations and in a better position to pass on changes in prices linked to exchange rates changes to consumers. Importers have also a preference for invoicing in local currency to minimize their exposure to currency changes

A lot more countries would like to develop local currency invoicing and use for trade purposes.

However, the number of currencies for which a real potential exist is limited (1) because of the high number of hard or quasi-pegs (2) because of the lack of internationalization of the currency – either because countries use “financial repression” to limit the use of their currencies (for example by implementing tight foreign exchange controls preventing capital account liberalization, either because of the limited trading (hence availability) of their currency internationally.

The largest potential exists of course in China. As shown in Figure 1, the RMB is under-utilized

relative to the share of China trade in global trade (according to Swift statistics, 0.2% of world’s payments, against a global trade share of over 11%). However, the internationalization of the RMB, notably in trade, and generally monetary and exchange reforms are at the forefront of the agenda of the Government and the central banks of China

Regional co-operation and local currency financing: a demand for it

•  A multi-pronged policy, focused first on trade The authorities of China have defined a step-by-step strategy aimed at opening up in a staged way

the financial relations between China and the rest of the world. The first step is under way and consists of encouraging the use of the RMB offshore, by reducing restrictions on RMB use in cross-border investment and trade. The regulatory agenda is aimed at encouraging the expansion of an off-shore market for the RMB in Hong-Kong mainly, with ramifications across Asia.

3 stages process:

The internationalization of the RMB

(source charts: HSBC)

RMB off-shore use is growing very rapidly, particularly in trade

The internationalization of the RMB

•  Summary v  The use of the RMB has increase over fivefold since the beginning of the RMB cross-border

trade settlement pilot scheme. The PBOC announces in December 2011 that more than 10% China’s trade is being settled in RMB. China allows the use of the RMB from HK (most transactions though), Macao and also most border trade with neighbours such Vietnam, Russia and Lao. The central bank has entered into swap agreements with Argentina, Australia and Indonesia. HK is likely to remain main market for some while, but developing in Singapore and London.

v  Other use of the RMB in the increase: HK’s RMB deposits doubled in 2011, RMB-denominated bond issuance, borrowing (essentially by “foreign investment enterprises” and FDI are also growing several fold.

v  A lot of trade and other RMB-related operations seem to be intra-firm trade. But also Asian markets and commodity exporters are adopting RMB as transaction currency. Appreciation expectations seem also to be an important driver of use. The question is whether the current trends will continue. For example, there is little “third-party use of the – parties that do not have trade relations with HK or mainland, China.

v  Risks and opportunities: linked to the pace of liberalization of China’s financial transactions, which itself depends on the pace of domestic financial reforms. While Chinese importers are free to use the RMB as a settlement currency, only designated exporters can for exports (albeit quite a large number). Key issue is whether RBM will be used in supply-buyer’s international relations. However, it is China’s policy, and greatest likelyhood that RMB become an international currency – starting with a trade settlement currency. The pace of which it happens depends on how reforms move forward smoothly but also internationally (Yu Yongding, 2012)

Internationalization of the RMB

Thank you for you attention!