NON-DELIVERABLE FORWARD MARKETS IN ASIAN CURRENCIES

by Ma Guonan, Senior Economist, BIS Representative Office for Asia and the Pacific, Corrinne Ho and Robert McCauley

Active, large and growing non-deliverable forward (NDF) markets trade mainly six Asian currencies. These offshore markets form an important part of the global and Asian foreign exchange markets, equilibrating market demand and supply in the presence of capital controls (Ishii et al (2001), Watanabe et al (2002)).

NDFs are foreign exchange derivative products traded over the counter. The parties of the NDF contract settle the transaction, not by delivering the underlying pair of currencies, but by making a net payment in a convertible currency (typically the US dollar) proportional to the difference between the agreed forward exchange rate and the subsequently realized spot fixing. NDFs are also distinct from deliverable forwards in that NDFs trade outside the direct jurisdiction of the authorities of the corresponding currencies and their pricing need not be constrained by domestic interest rates.

The NDF market offers an alternative hedging tool for foreign investors with local currency exposure or a speculative instrument for them to take positions offshore in the local currency. The use of Asian NDF markets by nonresidents in part reflects restrictions on their access to domestic forward markets (Table 1). However, in some cases, such as Korea, onshore players are also important counterparties in the NDF market of the home currency (Hohensee and Lee (2004)). The NDF markets for some Asian currencies have existed at least since the mid-1990s. Tightening of controls after the Asian crisis may have boosted their growth in some cases.

Turnover

Asia's NDF turnover accounts for the overwhelming majority of global NDF turnover. In particular, NDFs in the Korean won, the New Taiwan dollar, the Chinese renminbi, the Indian rupee, the Indonesian rupiah and the Philippine peso amount to some 70% of the emerging market NDF turnover globally, as measured by an Emerging Markets Traders Association survey in early 2003 (EMTA (2003)).

Turnover in the Asian NDF markets varies a great deal across currencies. While reliable, comparable and consistent statistics on NDF turnover are hard to come by, the available survey evidence and estimates by market-makers allow a rough ranking (Table 1). The Korean won NDF market has been the deepest NDF market in Asia as well as globally, with average daily trading volume in excess of $500 million and representing nearly half of the global emerging market NDF turnover. Turnover in the New Taiwan dollar NDF market has been the second most active in Asia. Given the relatively small amount of foreign investment in local currency bond markets, the high turnover in won and New Taiwan dollar NDFs may reflect the active participation of international investors in the Korean and Taiwanese stock markets, though currency hedging is more characteristic of international bond investors.

Market participants report that the shallower NDF markets in Asia have generally deepened over the past few years. As recently as three years ago, daily NDF turnover in the Chinese renminbi, Indian rupee, Indonesian rupiah and Philippine peso, respectively, was thought to be less than $100 million per day on average. However, the renminbi NDF turnover had grown rapidly since, to about $200 million in early 2003. Estimates of renminbi NDF turnover in 2003 vary, and indeed turnover is said to fluctuate a lot from day to day, but it seems to have doubled over the year. Turnover in the rupiah NDF market seems to have increased substantially from the first months of NDF trading in 2001, with increased non-resident investment in local currency bonds, equities and other assets. Indian rupee and Philippine peso NDF trading seems to have gained depth as well.

NDFs form an important part of overall forward trading in regional currencies. For the six Asian currencies being discussed, the reported NDF turnover represents some 10 to 20% of the combined trading volume of the onshore outright forwards, foreign exchange swaps and NDFs2. In the case of China, since domestic trading of outright forwards has only recently begun, and an onshore swap market does not yet exist, renminbi NDFs amount to some 90% of the estimated combined turnover of onshore deliverable forwards and offshore NDFs. Therefore, the importance of DNF markets should not be underestimated, for policymakers and market participants alike.

Liquidity

Liquidity varies with turnover across currencies as well as across maturities (Table 2). Judging by reported bid-ask spreads, the larger and more active NDF markets in Asia - those of the won, the New Taiwan dollar and the renminbi - are comparatively more liquid. The most liquid maturities of the Asian NDFs seem to be much longer than those of the main currency pairs globally, where the overwhelming majority of forward transactions span three months or less. In Asian NDF markets, most inter-dealer transactions are concentrated in the two- to six-month maturities, while some bank-customer trades even extend out to two to five years, in part due to the importance of foreign direct investment (FDI) in Asia.

Volatility

For the period under consideration, NDF volatilities have been consistently higher than their spot counterparts for all six Asian currencies covered (Table 3). This may be due to official intervention in the respective spot markets. Market participants rank the frequency of official spot market intervention as the highest for China and India, followed by the Philippines and Taiwan (China), and the lowest for Korea and Indonesia. Furthermore, the volatility of the Asian NDFs typically increases with maturity. By contrast, the spot and forward volatilities of the major currency pairs tend to be much more similar.

Market participants

The investor base for the Asian NDF markets is generally thought to have become broader compared with five years ago. This base mainly comprises multinational corporations, portfolio investors, hedge funds and proprietary foreign exchange accounts of commercial and investment banks. Both hedging demand and speculative demand are present in Asian NDF markets. In the case of the won and the New Taiwan dollar, portfolio investors and hedge funds are probably the most important players. In contrast, in the case of the renminbi, multinationals (given large FDI inflows into China in recent years) and more recently hedge funds (owing to heightened market speculation) probably play a greater role.

Differences in the offshore renminbi forward rates across maturities are said to reflect differences in the preferred maturity habitats of various market participants. The observation is that longer maturities show larger renminbi NDF premia (in the late 1990s) or discounts (recently) (Graph 1). Multinational corporate players probably trade along both short and long maturities, owing to their diverse needs. In contrast, hedge funds' bets reflect market analysts' often refreshed calls for an exchange rate policy change at a horizon of nine months or more. Hence the premia or discounts in the renminbi NDFs have tended to be larger at longer maturities, as speculative players positioned themselves for a possible renminbi devaluation during and after the Asian crisis or a possible revaluation after late 2002.

Within the Asia-Pacific region, the principal trading locations for Asian NDFs are in Hong Kong SAR, Singapore, Korea, Taiwan and Japan. Singapore is often thought to be the largest hub, according to the incomplete information available in the central bank 2001 triennial global foreign exchange market survey. Outside the region, New York and London are the principal locations for trading Asian NDFs.