In the turbulent world of foreign exchange, the seven most heavily traded currencies occupy a fairly rigid hierarchical order. But though some position shuffling does take place in the top ranks, those moves pale in comparison to the action on the next rung of the forex ladder. In recent years, a number of second-tier currencies have seen a huge increase in their share of global forex turnover, posing a challenge to the established hierarchy. While some of these seven currencies may be obvious, others are less so. Before we delve into learning more about these emerging currencies, let’s take a quick look at the colossal global forex market and the currencies that presently dominate trading in it.
Global Forex Turnover is Soaring
The Bank for International Settlements’ (BIS) triennial survey of forex turnover (or trading volume) is perhaps the most authoritative source of global forex trading data. According to the BIS survey conducted in April 2013, global forex market activity was a staggering $5.3 trillion per day in that month, an increase of 33% from daily turnover of $4 trillion in 2010. Forex turnover has more than quadrupled since 2001, when it was just over $1.2 trillion.
Total forex turnover is estimated to have declined by about $300 billion since the survey period to approximately $5 trillion, which still represents an impressive 25% growth rate from 2010. Expectations of a major shift in Japan’s monetary policy led to exceptional forex trading activity – particularly in the yen – in the run-up to the April 2013 survey.
The Established Forex Hierarchy
The 2013 BIS survey showed that the U.S. dollar continued to be numero uno by a very wide margin, contrary to occasional speculation about the greenback’s eventual demise. The U.S. dollar accounted for an 87.0% share of average daily forex turnover in April 2013. (Note that since two currencies are involved in each forex transaction, the sum of the percentage shares of individual currencies will total 200% rather than 100%.)
The next three positions were occupied by the euro (33.4% share), Japanese yen (23.0%) and British pound (11.8%). Among the major currencies, trading in the yen surged the most, rising 63% since the 2010 survey for reasons mentioned earlier. These top-four currencies have had the same ranks in the global currency hierarchy in this millennium, although their relative turnover share has fluctuated to a limited extent over the years.
The next three currencies in the April 2013 survey were the Australian dollar, Swiss franc and Canadian dollar. These currencies have swapped places among themselves since 2001. For example, the Australian dollar ranked seventh that year, but it doubled its share of global forex turnover since then to become the fifth-most traded currency in 2013.
Currency Challengers to the Status Quo
Four of the seven leading second-tier currencies are easy to identify, belonging as they do to the biggest emerging economies or BRIC – the Brazilian real, Russian ruble, Indian rupee and Chinese renminbi (or yuan). The other three currencies are less obvious – the Mexican peso, Turkish lira and South African rand. The collective share of average daily forex turnover of these seven currencies has increased from 6.2% in 2010 to 10.8% in 2013 (as mentioned earlier, the sum of individual currency shares totals 200%). Note that all seven currencies belong to emerging market economies (EMEs).
There has been a phenomenal increase in daily turnover for some of these currencies, with the biggest trading surges recorded by the Mexican peso, Chinese renminbi and Russian ruble. Turnover in the Mexican peso increased 171% from 2010 to $135 billion in 2013, giving the currency a 2.5% share of global forex trading and making it No. 8 among the most actively traded currencies. However, the biggest increase in forex trading was recorded by the Chinese renminbi, as daily turnover soared 250% since 2010 to $120 billion in 2013, giving it the No. 9 position among the most-active currencies. The Russian ruble also had a 140% increase in daily forex turnover to $85 billion, enabling it to climb four spots from 2010 to the No. 12 rank in 2013.
The increased share of forex turnover by these emerging currencies has come at the expense of major currencies such as the euro, Swiss franc and Canadian dollar. With the international role of the euro having contracted since the continent’s sovereign debt crisis erupted in 2010, euro forex turnover increased only 15% from 2010 to about $1.8 trillion per day. Although the euro remains the second most traded currency worldwide, its share of global forex turnover declined by almost 6 percentage points to 33.4% in 2013.
Carry Trades and the “Fragile Five”
Leveraged carry trades may partly explain the exponential increase in EME currency trading, but they are far from the only reason. Most of these seven currencies offer high interest rates, making them favored targets for carry traders. For example, as of May 22, 2014, the yield on 10-year government bonds in some of these nations was as follows – Brazil, 11.18%; India, 8.71%; and South Africa, 8.04%. Contrast those yields with the 2.55% yield on the U.S. 10-year Treasury, and it’s easy to see why those interest differentials may be so alluring to savvy traders.
But the high interest rates offered by many EME currencies are there for a reason - rampant inflation. A number of these emerging economies are also beset by structural issues such as growing current-account and budget deficits. In fact, these weak economic fundamentals led Morgan Stanley (MS) last year to identify a group of emerging economies as the “Fragile Five” – Brazil, Indonesia, India, South Africa and Turkey. These five economies have – on average – a budget deficit of 4.0%, current-account deficit of 4.1% and inflation of 7.5%. Concerns that tighter U.S. monetary policy would make it difficult for these nations to attract foreign capital to fund their deficits led to sharp declines in their currencies and stock markets from the summer of 2013 to early 2014.
According to an analysis by BIS staffers, quantitative forex strategies such as carry trades and momentum trades were unlikely to have been the main driver of turnover growth from 2010-13. Over this period, shrinking interest rate differentials due to easier monetary policy by many central banks, the narrow trading range for most major currencies and sudden policy actions – such as those taken by the European Central Bank during the debt crisis – made it an especially challenging time for quant strategies. As a result, quant currency hedge funds had substantial outflows, with assets under management declining from a peak of $35 billion in 2007-08 to just over $10 billion by 2013.
So What is Driving Forex Turnover?
Based on BIS data and findings, three main drivers may account for rapid growth in forex turnover of the emerging-market economies:
- Exceptional demand for OTC forex derivatives: Forex growth in the EMEs has been led by very strong demand for over-the-counter (OTC) derivatives such as currency forwards, swaps and options. OTC derivatives turnover rose by 41% over the 2010-13 period, from $380 billion to $535 billion, compared with an increase of 17% in spot-forex turnover. This supports the view that hedging demand and speculation by foreign portfolio investors is a primary driver of higher forex turnover.
- “Internationalization" of emerging-market currencies: Offshore trading – or trading of a currency outside the jurisdiction where it is issued – is a gauge of a currency’s “internationalization.” The offshore component has had the most rapid growth in EME currencies, especially for the Asian currencies such as the renminbi and rupee, with offshore trading contributing as much as 35 percentage points to growth of 41% in the 2010-13 period. The Chinese renminbi is playing an increasingly important role within Asia in this regard, with offshore turnover of $86 billion daily, which amounts to 72% of its global trading volume.
- “Financialization” of EME currencies: For decades now, the increase in global forex turnover has been magnitudes higher than underlying growth in the global economy or worldwide trade. Growth in EME forex turnover is no exception to this trend, implying that “financialization” of these currencies will continue. That said, part of the forex volume growth can be attributed to higher portfolio flows, with BIS analysis suggesting a positive and statistically highly significant relationship between portfolio inflows and outflows in emerging markets and forex turnover in the respective currencies. For instance, a 10% increase in cross-border fund flows is associated with a 7% increase in global forex turnover for Asian currencies, and a 10% increase for Latin American currencies.
The Table below shows the extent to which forex turnover exceeds GDP and total trade (imports and exports of goods and services) for these seven economies. The ratio of annual forex turnover (calculated on the basis of 250 working days in a year) to GDP ranges from a low of 3.6 for China to a high of 39 for South Africa, compared with an average of 63 for the seven most widely traded currencies. By that measure, the financialization trend of these seven currencies – in particular the BRIC nations – looks unlikely to change.
|Rank*||Economy||2012 GDP||2012 Trade||Daily FX||Est. Annual||Annual FX||Annual FX|
|(US$ billions)||(US$ billions)||turnover ($bn)||FX T/O ($bn)||Turnover / GDP||Turnover / Trade|
|* Global economy rank based on 2012 GDP|
The Bottom Line: As these seven economies continue to grow in size and stature in the years ahead, a combination of hedging and speculative demand, internationalization and financialization may lead to them accounting for an increasing share of global forex turnover for the foreseeable future.