When Do Currencies Become International?

James Sinclair
Sometimes it’s good to see our assumptions proven statistically. For example, we intuitively know that as the average income of a country’s population grows and the country develops, its currency is more actively traded beyond its borders. In fact, as income per capita rises, international trading of a country’s currency is likely to grow as much as 100 times as fast.

Robert McCauley and Michela Scatiagna of the Bank of International Settlements published in the December 2013 edition of the BIS Quarterly Review an update to their 2011 paper “Foreign exchange trading in emerging currencies: more financial, more offshore” (BIS Quarterly Review March 2011). Their thesis is that Forex volume evolves in a predictable fashion, with a greater proportion trading for financial, rather than trade, purposes as per-capita income rises – and does so on an increasingly cross-border basis.

McCauley and Scatiagna look at the ratio of a currency’s FX volume to its home country’s total trade (exports plus imports). They then plot that on a logarithmic scale against per capita income.

BIS Quarterly Review, December 2013 page 25

BIS Quarterly Review, December 2013 page 25

By this measure, the United States and Japan trade at similar levels of activity, taking into account per-capita income and trade. The authors theorize that per capita income is a proxy for financial depth, complexity and openness. It’s an interesting study, if only for how neatly the data fits into place.

In the 2011 paper, the authors observe also that these relationships exist largely irrespective of government controls on a currency as controlled currencies simply trade as an NDF where necessary. They look also at the outliers. For example, the Chinese renminbi yuan trades dramatically less than expected, especially compared to the Indian Rupee not because of currency controls but perhaps due to controls on equity flows – the restricted access to China’s stock markets compared with the considerable foreign investment in those of India. Also, high yielding currencies trade more actively reflecting a carry-trade.

This does fit nicely with the factors that I have always understood to be fundamental drivers of FX volume: cross-border capital flows, foreign direct investment and trade. Perhaps McCauley and Scatiagna are using per-capita income as a proxy for cross-border capital flows. It leads to a question: why not use that measure directly? The renminbi yuan would then be less of an outlier.

Of course there is also the outlier that always seems always to be an outlier in foreign exchange: the New Zealand dollar. It’s the currency in the diagram above JPY in 2013 and to the left and above in 2011. The authors refer to former central bank governor Dr. Alan Bollard’s remarks that the New Zealand dollar is a store of value that just happens to be used by a small country. Could it also be because the Prime Minister of that small country is a former Forex dealer? Of course not, but the thought is amusing.