Forex

Foreign exchange trading in Asian currencies has surged but is being held back by anti-speculation controls and carries time-zone risk through dollar settlement, a research paper at the BIS has found.

The authors of the report suggest that trading and risk management would be improved if settlement via the dollar gave way to use of an Asian currency.

The dollar played a role in "about 97 percent" of all cross trading involving Asian currencies in April 2007, the research says.

"The overwhelming use of the U.S. dollar as a vehicle currency heightens the vulnerability of Asian currencies to settlement risk," according to the paper.

Each step in a foreign exchange transaction is usually settled in the currency's country of issue, which means that deals involving U.S. dollars can be affected by the considerable time difference between Asian markets and New York.

"One currency might have to be paid before receipt of the other currency can be confirmed," the authors, Yosuke Tsuyuguchi and Philip Woolridge, say.

"This can result in sizeable, temporary counterparty exposures."

The paper concludes that "greater use of a regional currency in intra-regional transactions, in place of the U.S. dollar, is one of several ways in which settlement risk could be reduced."

The authors said Europe was an example of what could occur in Asia, noting that in the 1980s, before the creation of the euro, the Deutschemark gradually displaced the dollar in transactions between members of the European Union.

The findings and comments express the authors' own views and not necessarily those of the BIS, known as the central bankers' central bank, which distributed the paper, however.

Government controls

Trading in Asian currencies has grown substantially in recent years, rising in value to $249 billion a day in 2007, but activity is held back by government controls, the study says.

Turnover in 10 Asian currencies, excluding the yen, jumped 130 percent between 2004 and 2007, with the Hong Kong dollar accounting for 40 percent of daily operations, the research paper says.

Trading in the Chinese currency rose more than sevenfold from $2 billion in 2004 to $15 billion in 2007.

"Inflows to Asian equity markets made an especially large contribution to foreign exchange turnover in April 2007," coinciding with a surge in Asian stock prices and purchases by non-residents.

But "the combined turnover of Asian currencies is still only a small fraction of global turnover," accounting for about 7.5 percent.

In general, foreign exchange trading globally is 30 times the value of trade in goods and services, but trading Asian currencies is far below this ratio except in the case of the Hong Kong currency which exceeds it.

But the study also concludes that "the liquidity of Asian foreign exchange markets continues to be undermined by foreign exchange controls."

Although such controls, which regulate the buying and selling of the local currency, are aimed at minimising speculation and preventing currency misalignments, they impair momentum and growth on foreign exchange markets, according to the paper.

Among the 10 currencies studied, only the Hong Kong dollar and the Singapore dollar are not subject to controls.

The other currencies examined were the Chinese renminbi, the Indian rupee, the Indonesian rupiah, the Korean won, the Malaysian ringgit, the Philippine peso, the Thai baht and the New Taiwan dollar.

The authors say that in instances where controls are applied, central bank approval might be required for buying and selling currencies that are unrelated to financial account transactions.

The requirements are generally designed to discourage offshore trading in the currency "because it is more difficult to monitor than onshore trading."

It says: "This is typically done by making it difficult to settle onshore transactions through the accounts of an affiliate or correspondent bank located onshore -- in other words by restricting the cross-border deliverability of a currency."

As a result, onshore trading in Asian currencies is about twice as high as that for international currencies.

In addition, controls tend to limit the activities of non-residents in onshore markets.

The paper found that transactions with non-residents make up just 25 percent of onshore Asian currency trading against 50 percent for international onshore operations.

In China, non-residents were not allowed to participate in the onshore market.

"Asian currencies are predominantly traded onshore between residents, whereas international currencies are mostly traded offshore between non-resident ..."

"It seems likely that non-residents will remain minor players in Asian foreign exchange markets so long as offshore trading is restricted," the study predicts.