Exploring Local Currency Usage to Reduce Exchange Rate Risks in Asia

2019-01-31T22:32:38+00:00January 30, 2019|Blog|

Exploring Local Currency Usage to Reduce Exchange Rate Risks in Asia

Author: Junko Shimizu, Professor of Economics, Gakushuin University

The ASEAN+3 region as a whole is integrating more in terms of trade – the share of intra-regional trade increased steadily to nearly half of total trade by 2016. Yet, the region still relies heavily on the U.S. dollar for trade and investment transactions. The U.S. dollar is the dominant currency not only for invoicing and settlements in intra-regional transactions, but also as the reference currency for exchange rate policies and as a reserve currency.

Recent financial crises, however, have highlighted the risks of such an overdependence on the U.S. dollar, since a sudden shortage in its liquidity can affect East Asian economies irrespective of their creditworthiness. In addition, East Asian currencies’ asymmetric response to U.S. dollar fluctuation, which has been observed during crisis periods in the past, can have a negative impact on production networks expanding in the region. Therefore, promoting the usage of local currency can be a first step in enhancing the role of Asian currencies and in reducing the risks of overreliance on the U.S. dollar.

U.S. Dollar Popularity and the Rise of Asian Currency Use 

Compared to EU countries, whose intra-regional trade share is also high, the U.S. dollar’s dominance as an invoice currency is significant in Asia. Asian economies use the U.S. dollar not only for trade with the U.S. but also for trade with other countries, particularly for intra-regional trade. This is mainly because Asia does not have a regional common currency like the Euro. Instead, the U.S. dollar has played an important role as a vehicle currency in Asia for a long time thanks to its stability, liquidity and low associated transaction costs.

According to a survey conducted with Japanese firms by the Research Institute of Economy Trade and Industry, a Japanese think tank, there are several reasons why Japanese businesses choose the U.S. dollar for their trade transactions in Asia. First, exports from their Asian subsidiaries tend to be invoiced in U.S. dollars as long as the final market is the U.S. Second, the transaction costs associated with most Asian currencies vis-à-vis the Japanese yen are higher than those vis-à-vis the U.S. dollar. As such, using the U.S. dollar is the second-best way to shift currency risk from Asian subsidiaries to headquarters in Japan.

Data from the Bank for International Settlements (BIS), the Society for Worldwide Interbank Financial Telecommunications (SWIFT) and the International Monetary Fund (IMF) confirm the U.S. dollar’s dominance as a key currency in the foreign exchange market, in trade settlement and in the composition of foreign exchange reserves in Asia. Official data from China, Indonesia, Japan, Korea and Thailand on currencies’ share of trade in the region shows that some Asian currencies, such as the RMB and the Thai baht, have been utilized to a certain extent for trade settlement within the region. Although the share of local currency use is still small, it is important to know the progress in local currency usage through such data disclosures by governments.

The latest firm level survey questionnaire in Japan also suggests that it is becoming more common for Japanese manufacturing firms to use Asian currencies for their transactions in the region. In particular, RMB invoicing has gradually increased for intra-firm trade between production subsidiaries in China and headquarters in Japan. There are two reasons underpinning this development. First, the Chinese economy has become a larger market for final products from Japan; and second, Japanese subsidiaries in China are now finding it less cumbersome to use the RMB for trade transactions because of the improvement in the RMB markets.

Another survey with Korean and Chinese firms also suggests that the choice of invoicing currencies has begun diversifying recently to reduce firms’ overseas subsidiaries’ exchange rate risks. Direct transaction markets vis-à-vis the RMB and other Asian currencies help to increase RMB usage with neighboring countries, for example. Also, relatively stable exchange rates among Asian currencies in recent times lend support to the diversification in settlement currencies.

Following steps to internationalize the RMB, other Asian countries have recently started to use their local currencies in domestic transactions. In 2016, Bank of Thailand signed an understanding with Bank Negara Malaysia on direct local currency settlements between the baht and ringgit. Bank Indonesia also joined this cooperation in December 2017. This local currency settlement framework among the three ASEAN countries might bring structural changes of invoicing currency choice in Asia in the future.

Asian local currency usage is small but has been gradually increasing on the back of market-driven forces and government efforts. This is important as it provides local small and medium-sized enterprises (SMEs) with another option to use their own or neighboring countries’ currencies to reduce exchange rate risks. Bilateral direct transaction markets also help provide a wider choice of transaction currencies.

Looking Ahead

To promote the greater use of local currencies in Asia, it is important to support the development of local currency settlement framework among regional economies. This will create bilateral direct transaction markets to breed local foreign exchange markets, which will reduce the transaction costs of local currencies.

The availability and reliability of data related to invoice/ settlement currencies in the region also need to be improved. Such data disclosures make for good information, particularly for SMEs who are starting to participate in cross-border transactions and wish to know other firms’ choice of settlement currency. In this regard, further promoting data disclosure and regular surveys on local currency usage both in trade settlements and investments are indispensable to increasing local currency usage in the region.

* This article is the second part of a blog series that explores the possibility of local currency contribution to the CMIM in the ASEAN+3 region. Read Part 1 of the series.

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