Download Exotic Currencies in Foreign Exchange

Exotic Currencies
in Foreign Exchange
A guide to convertible and
non-convertible exotic currencies
By Timothy Woods
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Contents
Page
Introduction to exotics
3
Types of exotic currency
3
The changing global economy
4
The world’s top ten exotic currencies
5
Top ten exotic currencies in detail
5
Currency black markets
7
7 tips for a CFO
9
What is the future of exotic currencies?
10
Conclusion
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Introduction to exotics
Exotic currencies bring with them considerable confusion and a widespread lack of understanding. If
considering operating in a country with an exotic currency, it is absolutely essential to fully understand what
your business is getting into before making any decisions. As an FX currency provider, at Kantox we have
received numerous queries from clients about how to solve the exotic currency problems that they found
themselves in. In most cases it was already too late to remedy the situation. Many businesses considering
trading with exotics are not nearly educated enough in the intricacies and potential problems that exotics bring.
In this guide, we aim to remove the mystique associated with exotics, aid understanding in an easy-to-digest
manner, and provide advice to CFOs and other business decision-makers regarding approach and
management of this type of currency.
Currencies typically fall into one of three classes, decided by the trading volumes, liquidity and availability of
the currencies. The first group is made up of the world’s major currencies, such as the US dollar, euro and
British pound. Second are the minors, including the Canadian dollar, the New Zealand dollar and the
Australian dollar, though increasingly the Australian dollar is mentioned as a major, as its trading volumes
have risen in recent years.
The third group is made up of the exotic currencies, which typically come from countries that are not fully
developed. Exotics consist of three types of currency: (1) Fully convertible (2) Partially convertible and (3)
non-convertible currencies. There are a total of 17 major, minor and exotic currencies together that are fully
convertible. That is, they may be exchanged in the global foreign exchange market without any limitations and
without any government intervention in the process.
Types of exotic currency
(1) Fully convertible
A fully convertible currency can be traded without any limitations imposed by government. They
typically come from more stable countries, although there are some exceptions. The Mexican peso is
an example of a fully convertible, exotic currency.
(2) Partially convertible
A partially convertible exotic currency is the legal tender of a country that is traded in low volumes on
the global foreign exchange market. The exchange of the partially convertible currency is partly
controlled by the state that issues it. The Indian rupee is an example.
(3) Non-convertible
Non-convertibles are also known as “blocked currencies”. A non-convertible currency is the legal
tender of a country that is not traded at all on the international FX market, usually because of
government restrictions. It is normally a method of protection as an exotic currency’s economy is
usually particularly vulnerable to market movements. If the exotic currency decreases or increases in
value sharply, its potential adverse effects could be devastating for a country. The only way to trade a
non-convertible is on the black market. The Brazilian real and Chilean peso are two examples of nonconvertibles which represent considerable challenges for businesses operating in Brazil and Chile,
respectively.
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The changing global economy
Emerging markets are becoming more prominent in the global economy year-on-year. As we head towards
2020, 70% of global GDP’s growth is expected to come from emerging markets. The main players will likely
be China and India, followed by Russia and Brazil. Another developing trend is the listing of companies on
stock exchanges away from the predominance of the NYSE, NASDAQ and London Stock Exchange.
“Samsonite opted to list its shares on the Hong Kong stock exchange instead of on the NYSE. Prada did the
same, and L'Occitane International listed in Hong Kong as well back in May,” as reported in Forbes. This is
because companies are now moving to markets and currencies where they see future growth. This will almost
certainly have an impact on global trading levels involving exotic currencies that come from the strongest
emerging markets.
Table showing the percentage of world market cap from 2005 to 2013 (Source)
Image: Money makes the world go 'round by Linus Bohman licensed under CC BY 2.0
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The world’s top ten traded exotic currencies
(Data obtained from the 2013 BIS survey)
The following table shows the top 10 traded exotic currencies in global FX. Even the most popularly traded
exotics are traded infrequently and make up only a tiny fraction of global FX.
Currency
Ranking
Among
Exotics Only
Currency
Globally Traded
Currency Ranking
Among All Currrencies
Global FX Market %
(Involved in one side
of global FX trades)
1
Mexican peso (MXN)
8
2.50%
2
Chinese yuan (CNY)
9
2.20%
3
Russian ruble (RUB)
12
1.60%
4
Hong Kong dollar (HKD)
13
1.40%
5
Singapore dollar (SGD)
15
1.40%
6
Turkish lira (TRY)
16
1.30%
7
South Korean won (KRW)
16
1.20%
8
South African rand (ZAR)
17
1.10%
9
Brazilian real (BRL)
19
1.10%
10
Indian rupee (INR)
20
1.00%
Figures based on 2013 data compiled by the BIS survey.
To contextualise this data, the US dollar is the most traded currency in the world, on one side of the
transaction in 87% of global trades. The euro is second, at 33.4%. The information in the table shows the
different types of exotic currency: Fully convertible, with no restrictions on their trade; partially convertible,
where different restrictions are in place, which differ based on the currency; or entirely non-convertible, where
often the only way to access these currencies is through non-deliverable forwards.
Top ten exotic currencies in detail
(data obtained from Credit Suisse)
(1) Mexican peso (MXN)
 Free-floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 1 year
 2.5% of global FX market share (out of 200%)
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(2) Chinese yuan (CNY) / also known as the “renminbi”)
 Managed, non-convertible (offshore Chinese yuan (CNH) is freely convertible, deliverable offshore in
Hong Kong)
 Spots upon request / liquid deliverable forwards possible with NDF contracts (typically settled within
one month to a year)
 2.2% of global FX market share (out of 200%)
 China is currently going through a process of opening up the yuan to be traded freely on the global FX
market. It could be fully convertible by 2015, with some commentators suggesting it will become the
world’s reserve currency in the not-too-distant future, replacing the US dollar.
(3) Russian ruble (RUB)
 Managed free-floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 1 year (NDF offshore ruble market is
also prominently used)
 1,6% of global FX market share (out of 200%)
(4) Hong Kong dollar (HKD)
 Managed free-floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 3 years
 1.4% of global FX market share (out of 200%)
(5) Singapore dollar (SGD)
 Managed free-floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 2 years, MAS restrictions on
offshore SGD lending
 1.4% of global FX market share (out of 200%)
(6) Turkish lira (TRY)
 Free-floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 3 years
 1.3% of global FX market share (out of 200%)
(7) South Korean won (KRW)
 Managed floating currency, partially convertible (offshore settlement not allowed due to Korean
government restrictions)
 Spots available only on documented commercial transactions / forwards typically processed through
NDFs
 1.2% of global FX market share (out of 200%)
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(8) South African rand (ZAR)
 Free floating, fully convertible
 Spots fully convertible / liquid deliverable forwards possible up to 2 years
 1.1% of global FX market share (out of 200%)
(9) Brazilian real (BRL)
 Non-convertible (Brazilian real cannot be transferred out of Brazil)
 Spots non-convertible / forwards possible through NDFs with US dollar, usually up to 2 years
 1.1% of global FX market share (out of 200%)
(10) Indian rupee (INR)
 Managed float, partially convertible
 Spots: only purchase of INR is possible / forwards possible through NDFs typically up to 1 year
 Foreign nationals are legally prohibited from importing/exporting INR whereas Indian nationals can
import and export only up to INR7,500 at a time
 1.1% of global FX market share (out of 200%)
 Due to the INR’s growing importance in international FX markets, there is talk of altering the rupee
into a fully convertible currency, though as yet, there is no definite plan to do so.
Image: Electrochemical Currency Exchange Co by Christopher Adams licensed under CC BY 2.0
Currency black markets
A currency black market is the consequence of government-implemented artificial official FX rates and a
subsequent lack of foreign currency available. There are then effectively two exchange rates in a country: The
official rate and the unofficial, black market rate. Many exotic currencies have black markets, where illegal
trading of a country’s currency takes place, nearly always in cash, as the parties to the illegal transaction do
not wish to leave a trace. Black markets gain prominence when countries typically reach a point of economic
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woe where interest rates may be high, imports and access to foreign currencies is restricted and in general,
confidence is lost in the value of the currency by its home citizens. Due to currency controls imposed by
government on foreign currency access, people often turn to the foreign currency black market in order to
protect their finances. They usually pay a significant premium on the black market compared to the real
exchange rate. Countries which are currently experiencing problems with currency black markets include
Argentina, Venezuela and Egypt.
Venezuela, for instance, is a particularly striking example. The Venezuelan currency, the bolivar, has lost
much of its value against the dollar in recent years. As the availability of US dollars has dried up, and amid a
backdrop of social unrest due to hyperinflation and nationwide shortages of food, citizens have turned to the
black market in order to gain access to US dollars. The official cost of 1 US dollar has been fixed by the
Venezuelan government at 6.3 bolivars, though this exchange rate is reserved for imports of medicine and
food. In February of this year the black market said otherwise, quoting 90 bolivars. Now there is, in effect, “a
two-tier society, similar to the Soviet Union and Cuba”. The first tier is made up of people with access to US
dollars, which includes prostitutes and expatriates. The second consists of people with no access to US
dollars. The first tier is, of course, in a much healthier position. The second tier will have seen their quality of
life likely reduce sharply.
Venezuela’s official bolivar- US dollar exchange rate, at 6.3:1, is much lower than the black market rate, which recently fell from 90
bolivars to 58, before rising again. Source
One of the effects of this two-tier society is that Venezuela simultaneously becomes both very affordable and
very expensive; Caracas is either among the cheapest or among the most expensive capital cities in the world,
depending on if you have US dollars or not. On the black market, one dollar buys more than ten times the
number of bolivars than the official exchange rate.
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7 tips for a CFO
(1) Analyse your business needs in the exotic currency market
Try to stay away from exotics as much as possible, as they are illiquid, highly volatile and are usually
only available to buy at very high fees. Unless it is essential to your business, focus on other markets
with more accessible currencies. Does your business absolutely need to work in the exotic currency?
Is there no alternative? If not, ensure that you are fully aware of the high fees, spreads and volatility
risk associated with the exotic currency and how it may affect your business.
(2) Explore using major currencies
Look to reach agreement with your suppliers in the exotic currency denominated country to complete
transactions in a more liquid, less costly major currency, such as the US dollar or euro. This may
mean bearing the full costs of the FX transaction or if not, the counterparty to the transaction may add
a premium to their charge. Ultimately, it is infinitely safer and worth the extra cost.
(3) Understand costs
Be fully aware of the high spreads, FX costs and high volatility associated with exotic currencies that
you are considering operating with. Most major currency pairs all include the US dollar on one side of
the exchange. The EUR/USD pair is the most traded in global FX, accounting for a whopping 30% of
daily trades globally. Spreads on major currency pairs are typically the lowest in foreign exchange. In
contrast however, spreads on an exchange involving an exotic currency are typically very high, due to
their poor liquidity and high volatility.
(4) Understand the currency
Ensure that the exotic currencies you operate with are fully understood. Ascertain their volatility and
liquidity, and identify the macroeconomic factors and possibility for political or social instability. Such
factors influence a currency’s value. Lastly check with your FX provider on the currency’s availability
and the potential roadblocks or difficulties in transacting with it.
(5) Protect your business through hedging
Explore the possibility of using financial products to protect your business against volatility, such as
forward contracts or swaps. To optimise this step, ensure you compare a selection of FX service
providers. Read our blog post on tips for benchmarking and comparing service providers here.
(6) Explore the use of non-deliverable forward contracts
A business can gain exposure to accessible non-convertible currencies through the following method,
explained by Kantox co-founder, Antonio Rami:
“Non-convertible currencies such as the Brazilian real are not traded in the spot or forward currency
markets like the US dollar or euro. To remedy this, non-deliverable forward (NDF) contracts are used
to allow access to a non-convertible currency. NDFs have a similar purpose as a regular forward
contract, and they are the principal way to gain access to non-convertible currencies”. Antonio Rami,
co-founder of Kantox.
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(7) Talk to your FX provider
Ensure you talk to your provider, or even a multitude of potential providers to ensure you can trust
them regarding business opportunities working with exotic currencies. Ask smart questions and
ensure they can back up their claims with facts and proof. If your FX provider is experienced in the
exotic currency you need to work with, they may also be able to put you in touch with other
companies to share knowledge and best practices with you on how to best manage your approach.
What is the future of exotic currencies?
The vast majority of exotic currencies will continue to represent huge risks for businesses should they expose
themselves to them. However, the future for many exotics will be shaped by the respective fortunes of their
own economy. As the global economic landscape is shifting at such an incredible rate, with developed
countries’ growth likely to be left in the shade by emerging economies in coming years, increasing importance
will naturally fall upon currencies with growing presence. A liberation of many non-convertible and partially
convertible currencies will possibly occur, either to fully convertible or less restricted, as such emerging
economies grow in economic stature, led by the juggernaut, China, followed by India. China’s renminbi and
India’s rupee are expected to be fully convertible over the next few years, as their restrictions are loosened.
This will of course make trade with these currencies much easier and more accessible, reducing costs, time
and risk for companies. However, the majority of exotics will remain non-convertible or under a different
degree of partial convertibility based on the amount of government restrictions in place, and so, caution is
advised.
Conclusion
We would advise you to stay away from exotic currencies where and whenever possible. However, if your
business absolutely needs to trade in an exotic, it is essential that you fully understand it inside out. How
volatile is it? What is your risk tolerance to such volatility? What are the macro and microeconomic factors you
should be aware of as well as political stability of the market you have exposure to? Especially important,
what are the risks of having your company’s money trapped in a foreign country? Can your company afford to
run the risk of having capital out of reach, and of it being exposed to exchange rate volatility if changing to US
dollar, for instance? Remember that exotics carry a high risk of swinging rate fluctuations. These are the
questions you should be asking and following through on in order to protect your business and its profit
margins when dealing with exotic currencies. If not, your business runs the risk of falling victim to one or more
of the obstacles that exotic currencies give rise to. With FX in general, be it an exotic, major or minor currency,
it is advisable to invest capital to protect your business through hedging and an effective FX management
strategy. However, with exotics in particular, investing even more time, capital and labour in ensuring you
business and profits are protected is vital, as the risks are that much greater.
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