CHINA’S OPPORTUNITY
: FX TRENDS IN THE 21ST CENTURY
The
China Foreign Exchange Trade System and the State Administration of Foreign
Exchange have instituted many changes in the last decade. E[1]È^
The result E[1]È^
is an interbank FX market that today is healthy and steadily growing. Indeed,
it has responded well to reforms designed to increase volumes.
These reforms have been watched - and
helped - by those of us in the West with great interest. E[1]È^
As the top-ranked foreign bank for turnover in the Chinese interbank FX and
money markets, BMO Financial Group is extremely encouraged and excited by what
we see, both now and for the future.
FX trading volumes are expected to
increase dramatically in the next five years as global trade with China
continues its rapid ascent. New reforms to extend interbank trading hours,
provide incentives to lower commissions and boost interbank trading interest
will all help to increase trading volumes, as will China's entry into the WTO.
There is little doubt that these changes
are paying great dividends for China. My message to you today is simple: E[1]È^
embrace change. As you are confronted with new challenges and opportunities, I
encourage you to think - and to look - ahead. E[1]È^ Try to envision a FX
policy that will stand the test of time - one that is best suited to China's
emerging role as a global economic leader.
At BMO Financial Group, one of my
responsibilities is running one of North America's leading global FX
operations. E[1]È^
From my vantage point, I have identified three emerging trends that I believe
you should keep in mind as you develop a robust FX trading policy that will
take China well into this new century.
TREND 1 - the emergence of
flexible currency systems
The
first trend is the emergence of flexible versus fixed-rate currency systems.
China, of course, has a managed floating
system. E[1]È^
The RMB has been stabilizing at 8.28 to US dollar over the past five years. E[1]È^
This does not mean that the yuan has remained stable against all currencies. E[1]È^
In fact, the U.S. dollar's steady rise against most major currencies until
early 2002, as well as its subsequent downfall, has taken the yuan on a similar
rollercoaster ride. E[1]È^
But at least with respect to the most widely traded currency in the world - the
dollar - the yuan is fixed.
The choice of exchange-rate system has
long been a source of contentious debate among analysts, and I am the first to
acknowledge that both sides have legitimate arguments in their favor. But in
recent years, more and more emerging economies have moved toward flexible
systems.
According to the International Monetary
Fund, 97 percent of its member countries in 1970 were classified as having a
fixed or "pegged" exchange rate. E[1]È^ By 1980, that share
had declined to 39 percent. E[1]È^
And in 1999, it was down to only 11 percent.
The reason for this shift to floating
currency systems, I believe, is that our world is volatile - and growing more
so every day. E[1]È^
While fixed FX rate systems have some
benefits, they also have some drawbacks. Economies with fixed exchange rates
may have difficulty adjusting to external shocks. E[1]È^ Countries with fixed
exchange rates have less independent control over domestic inflation trends. E[1]È^
What's more, a fixed system greatly reduces the flexibility of the central bank
to adjust interest rates to stabilize the economy following a shock.
Fixed exchange rates can also be a
problem when a nation ties its currency to another currency that itself is experiencing
wild swings. E[1]È^
For example, the U.S. dollar has fallen sharply since the start of 2002, so any
currencies pegged to it have also depreciated significantly against the rest of
the world. E[1]È^
The U.S. dollar may be in a medium-term bear market, due to its massive trade
deficit, so any currency tied to it could also face a steady period of weakness
in the years ahead. E[1]È^
A depreciating currency often translates into a decline in a nation's living
standards vis-ˆ-vis the rest of the world.
These problems don't manifest themselves
in flexible currency systems. Flexible exchange rate systems provide monetary
independence, which is needed to run a monetary policy that is suited to a
country's own distinct economic structure. E[1]È^ E[1]È^
When Canada witnessed a decline in commodity prices during the late 1990s, our
currency weakened against the U.S. dollar. E[1]È^ The depreciation
helped cushion the pain for domestic resource companies through increased
exports. Now that commodity prices have recovered, the Canadian dollar has
strengthened in turn. E[1]È^
What's important to note here is that the decline in the Canadian dollar,
though not permanent, actually helped insulate the domestic economy from the
external shock.
Research by the Bank of Canada has shown
that countries with flexible exchange rates are associated with higher economic
growth - but only to the extent that they are open to capital flows. E[1]È^
Moreover, a country must have well developed financial markets to benefit from
a flexible exchange rate system. E[1]È^
Fixed currency systems may be suitable if the structure of a country's economy
is similar to that of the country it wants to peg its currency to. (This is not
the case between Canada and the U.S. given Canada's greater reliance on natural
resource production.) E[1]È^
Flexible exchange rate systems are generally associated with more mature
economies, backed by a strong institutional framework.
In short, a flexible currency system is
often desirable, provided that it is supported by sound economic policies. One
such policy is to target a low inflation rate, which provides a nominal anchor
for both monetary policy and the floating exchange rate.
To be sure, flexible exchange rate
systems come at a cost. E[1]È^
Relative to fixed systems, the higher costs stem from the greater number of FX
transactions as well as hedging activity to protect against adverse exchange
rate movements. E[1]È^
I would like to say one more thing on
this subject. E[1]È^
And that is that some developing economies have found it useful to have a fixed
rate system during the transition from developing to developed. The main reason
for this is to give the developing economy time to adjust - as a fixed rate
system can help insulate its financial system from rapid shifts in global
investor sentiment.Additionally, a fixed rate system can help a developing
economy move from a high inflation rate to a low and stable inflation rate if
the currency is pegged to a strong currency of a low inflation nation.
In China's case, such an evolving policy
may be necessary for a big economy undergoing such great changes. E[1]È^
What's more, it is important that changes only take place when people are fully
convinced that change is good.
Trend 2 - the emergence of
"super" currencies
The second trend is the emergence of
so-called "super" currencies. I define a super currency as a true
international currency, in that it is widely known and used throughout
The
world and associated with a major economic trading zone.Today, two currencies
can legitimately lay claim to super currency status: E[1]È^ the U.S. dollar and
the euro.
The
U.S. dollar accounted for 45.2 percent of total daily FX transactions in 2001,
up from 41 percent in 1992. E[1]È^
The euro was the second most popular currency with an 18.8 percent market
share. E[1]È^
In fact, the dollar/euro exchange rate was the most traded currency pair in
2001, accounting for nearly one-third of global turnover.
The
yen was the third-most used currency at 11.4 percent of global turnover, while
the British pound was fourth at 6.6 percent.
Besides
these four currencies, no other single currency accounted for more than 4
percent of global turnover. E[1]È^
In fact, all the other currencies combined comprised less than one-fifth of
total turnover. E[1]È^
For this reason, they are widely known as "secondary" currencies in
FX markets.
Most
secondary currencies are closely associated with one of the two super
currencies and are often called "trading-bloc" currencies. E[1]È^
For example, the Canadian and Australian dollars are often associated with the
U.S. dollar and are therefore called dollar-bloc currencies. E[1]È^
When other major currencies rise in value against the U.S. dollar, they
sometimes appreciate against the dollar-bloc currencies. E[1]È^
Similarly, the northern European currencies, the Danish krone and the Swedish
krona, tend to track movements in the euro.
The
East Asian currencies, like the South Korean won, Singapore dollar, Taiwan
dollar, Thai baht, and Indonesian rupiah are predominantly linked to the yen,
and are sometimes called yen-bloc currencies.
Achieving
super currency status grants several benefits to a nation, provided of course
that the currency is supported by sound economic policies.
The
first benefit is convenience. E[1]È^
A super currency is widely used in global business and personal transactions. E[1]È^
For example, an American citizen can travel most anywhere in the world with the
confidence that local businesses will accept the U.S. dollar. E[1]È^
The same can't be said for the citizens of secondary-currency nations.
The
second benefit is the result of support from global central banks. E[1]È^
Super currencies are usually held by central banks as part of their FX
reserves. E[1]È^
This tends to support the value of the super currency. E[1]È^ For example, during
the U.S. stock market correction of 2000 to 2002, it is widely believed that
the U.S. dollar would have fallen markedly against most of the major currencies
had it not been for the consistent purchase of U.S. Treasury notes by many
central banks. E[1]È^
The stability, and in fact strength, in the U.S. dollar during this critical
period allowed the Federal Reserve to cut interest rates more aggressively than
may have been the case had the greenback plummeted to insulate the U.S. economy
from the devastating impact of the market downturn.
A
third benefit stems from the super currency's so-called "safe-haven"
status. E[1]È^
This is important for maintaining financial market stability in the
super-currency nation during periods of global financial crises. E[1]È^
In theory, greater stability in exchange rates implies less uncertainty about
future exchange rate levels. E[1]È^
The accompanying lower risk premium attached to the currency should imply lower
real interest rates, which in turn encourages investment and facilitates
economic growth in the super-currency nation.
Finally,
the establishment of super-currency status provides political clout for a
nation, which is a tremendous benefit in an increasingly globalized economy.
So
what are the pitfalls of not being a super currency? E[1]È^ Or to put it more
bluntly, of being a secondary currency?
Well,
secondary currencies have a lot of fair-weather friends. E[1]È^
Remember what I said about our living in a volatile world? E[1]È^
Periods of global financial crises - for example the 1995 peso crisis, the 1997
Asian currency crisis and the 1998 Russian debt default - led to
flight-to-quality buying of super currencies and attendant capital flight from
secondary currency nations. E[1]È^
As a consequence, the secondary currencies plunged in value and interest rates
spiked higher, thereby depressing domestic economic growth.
E[1]È^
I
like using Canada as an example, so I'll continue. E[1]È^ Following the 1998
Russian debt crisis, the Bank of Canada was compelled to hike interest rates a
full percentage point in one day in order to stop the slide in the Canadian
dollar. E[1]È^
In contrast, the rising value of the U.S. dollar eventually allowed the Fed to
reduce interest rates to bolster the U.S. economy during that time of stress. E[1]È^
The
upshot is that it's better to be a super currency than a secondary currency. E[1]È^
In fact, the only real benefit of being a secondary currency is that in times
of global financial market distress, the currency often weakens, thereby
enhancing external competitiveness. E[1]È^
And, provided that the depreciation is orderly, the central bank can still
reduce interest rates to stimulate domestic demand.
I
believe there is an opportunity for an Asian super currency to emerge. E[1]È^
This new super currency may follow one of several paths:
*The
East Asian currencies may increasingly become yen-bloc currencies; or
*The
East Asian currencies could form a single currency union like the Euro-zone and
become a super currency; or
*China's
currency may one day float, superceding the yen to become a super currency and
eventually emerge as a yuan-bloc currency for East Asia.
The
path chosen will depend on the direction that the Chinese and other Asian
governments take in the years to come.
Trend 3 - the emergence of technology
Finally, the third trend is the emergence
of technology as it applies to FX trading.
I'd
like for a moment to draw on personal experience with my own organization, BMO
Financial Group. E[1]È^
Back in 1996, we became the first bank in North America to offer a fully
independent, Internet-based banking service. E[1]È^ It cost us a lot to
develop, and ultimately was unsustainable as a stand-alone service. E[1]È^
However, the lessons we learned were invaluable.
Had
we not developed an online banking option, our customers would have gone to our
competitors. E[1]È^
Today, the volume of our electronic banking transactions eclipses that of our
retail branches. E[1]È^
The message is simple: E[1]È^
if companies don't adapt to the changing needs of their clients and incorporate
new technologies, they face extinction.
And
so it is with FX trading. E[1]È^
Today, the interbank FX world is linked through powerful trading platforms such
as Reuters and EBS. E[1]È^
These platforms level the playing field and allow new players like China to
enter the market fairly. E[1]È^
Electronic systems play no favorites - if you have the best price in the
market, then your transaction will be the first one executed.
Electronic
trading is now the dominant method in the interbank FX market and although, so
far, it is used less in transactions between banks and their customers, this
trend is changing. E[1]È^
Strong global competition has led banks to actively promote new systems to
their customers in order to retain their businesses. E[1]È^
Unfortunately,
these platforms are expensive - and in a business where the margins are already
extremely low, it can be hard to find a way to pay for them. E[1]È^
I want to point out that the disadvantage of these systems is that customers
lose the "personal" touch. E[1]È^
Therefore, you need to offer your customers both solutions - electronic and
personal contact - in order to keep them happy.
At
BMO Financial Group, we have found that a combination of technology and
personal advice is a good formula. E[1]È^
While clients may be happy to transact smaller routine transactions using
electronic distribution systems, they usually prefer to talk to an advisor when
doing something complex or unusual. E[1]È^
The institution that succeeds will be one that provides a good combination of
both channels.
Summary
In
summary, the three emerging trends I have just outlined are all factors that
you will need to take into account as you develop a versatile and appropriate
FX trading policy for China.China's road ahead has many options. E[1]È^
But if the past is any guide, I am confident you will make the right decisions.
E[1]È^