Currency internationalisation: Opportunities and risks in emerging markets

Last week, Leeds University Business School, together with the University of Liverpool Management School, hosted an event on “Currency Internationalisation: Opportunities and Risks in Emerging Markets” at the University of Liverpool’s London campus.

The event, which was part of the Business School’s Ideas in Practice programme, saw the launch of a new major report, sponsored with funds from the UK Foreign and Commonwealth Office’s Prosperity Fund, on the Internationalisation of the Brazilian Real. We produced the report, along with Dr Johannes Jäger, University of Applied Sciences Vienna, as part of our research into currency internationalisation in emerging market economies.

Background

Brazil’s economic importance has increased substantially in the past 10 years; the country is consistently ranked among the 10 largest economies in the world. However, despite relevant improvements in the past decade, Brazil’s financial and capital markets still have room to grow and to further support long term sustainable economic development.

The report is the product of a UK-Brazil cooperation research project aimed at addressing important challenges to help further integrate Brazil into global financial markets.

The project - “Analysing the Integration of Brazilian Financial Markets” - was supported by the UK Prosperity Fund in partnership with the Central Bank of Brazil and the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários – CVM).

Information gathered and produced in the context of the project was crucial for introducing the discussion surrounding the convenience, risks and benefits of increasing integration and furthering the internationalisation of Brazil’s financial system and currency (the Brazilian Real - BRL) especially in Latin America and London.

The initiative was conducted by an interdisciplinary team and included academic research, meetings with private and public sector relevant stakeholders and separate missions to the UK and Latin America in the period of two years.

Objectives

The three main objectives of the consultancy report were to:

1. Analyse the convenience and risks of the internationalisation of BRL and the wider trade of BRL assets abroad
2. Investigate the implications of currency internationalisation on monetary and financial stability policies
3. Develop concrete policy recommendations on how to move forward with currency internationalisation and regional financial integration in Brazil.

The case for currency internationalisation

The process by which a currency assumes cross-border roles is called currency internationalisation. In this process, foreign nationals acquire the domestic currency to perform (international) money functions. These operations can take place onshore in the domestic financial market, and offshore in international financial markets. The broader and related concept of financial integration includes all financial relations with foreign operators, including those denominated in foreign currency (eg US$ denominated debt issued by Brazilian nationals).

Both currency internationalisation and financial integration take place within a complex context, the understanding of which requires a comprehensive, yet fine-grained, analytical approach. In analysing how the Real should be internationalized, it is essential to consider, on the one hand, how financial investors operate within global financial markets and in relation to different currencies, particularly in relation to the Brazilian financial markets and the Real.

On the other hand, it is important to consider how the process of currency internationalisation could support Brazilian growth in the best manner possible. The decision to be made is which type of currency internationalisation is appropriate. This decision should depend on the respective costs and benefits of different types of currency internationalisation.

Main arguments

Our main findings from the research are that:

• Currency internationalisation is not a linear process, but we observed different types of currency internationalisation depending on the functions national currencies assume in the international economy
• Different types of currency internationalisation have varying implications for asset price dynamics, external vulnerability, monetary policy, and ultimately economic development
• Different types of currency internationalisation have to be seen in relation to  countries’  growth models which they can either complement or undermine
• The peculiar position of emerging market economies in an asymmetric international monetary system means they are more like to assume certain (speculative investment) types of currency internationalisation.

These main findings lead us to two general policy conclusions. First, emerging market economies should seek to render strategies of currency internationalisation complementary to catch-up development strategies. Second, there is a need for an increased role for policy management and governance.

In extensive empirical research we show the varying implications different types of currency internationalisation have for exchange rate volatility and external vulnerability. In particular, we show that a high share of short-term financial investors in a currency significantly increases exchange rate volatility and the sensitivity to international market conditions. The impact seems to be the reverse one if non-financial corporations and long-term investors trade the currency. We also show that large open net foreign currency positions (funding gaps) increase exchange rate volatility.

Based on these empirical findings, for Brazil specifically we propose a strategy of currency internationalisation which would involve the facilitation of the establishment of the Brazilian Real as a regional trade-related vehicle currency and potentially, in the medium or long-term, as a funding currency, to support a productivist and trade-related accumulation regime.

Our concrete policy recommendations are that a broad range of institutions and relevant political agents need to:

1. Develop and extend regional payment, clearing and settlement mechanisms.
The Brazilian Real’s role as invoice and vehicle currency for trade remains limited regionally. The development of effective structures would be essential for deepened regional integration and using the currency at the regional level, in particular, the development and expansion of the existing Local Currency Payment System (SML).

2. Commission a study to analyse the risks and opportunities of a more elaborate system of bilateral swap agreements.
The international financial crisis has shown the substantial disruptions that can result from financial shocks to the provision of trade-related finance and, consequently, the conduct of trade. The provision of emergency liquidity in regional currencies would thus be essential to support regional trade flows and the denomination of these flows in regional currencies. A system of bilateral swap agreements (BSAs) could provide such emergency liquidity to a trade-related Local Payment System denominated in regional currency.

3. Enhance collaboration, macroeconomic and policy coordination and harmonisation between regional central banks and regulatory agencies.
In the medium term, successful currency regionalisation would require a certain degree of macroeconomic coordination and harmonisation. The synchronisation of business cycles and key macroeconomic variables would be essential to support regional trade and the use of regional currencies. 

4. Commission a study of the costs and benefits of introducing regional currency derivatives to hedge regional exchange rate risk. 
At the moment, all regional currency hedges have to be performed through US Dollar instruments, which further strengthens the role of the US Dollar in the region and increases the cost of regional currency hedges. The introduction of regional currency derivatives could reduce these problems. The introduction of new financial instruments could create new financial risks through, hence why a careful study of the costs and benefits of such new financial instruments would be warranted.

5. Introduce special credit lines mediated through specifically assigned dealer banks to enhance offshore settlement in Real. 
Access to Brazilian Real offshore could be enhanced through selected channels to facilitate the conduct of international trade and support the internationalisation of the Real as trade related vehicle currency.

6. Maintain counter-cyclical macro-prudential measures as part of the macroeconomic toolkit.
The experience of the recent international financial crisis and subsequent waves of international capital flows have shown the importance of countercyclical macro prudential measures to avoid domestic asset booms, financial instability and negative effects on domestic asset prices (including the exchange rate).

7. Support the establishment of the Brazilian as (regional) funding currency in the long-term.
Large open currency positions by foreign investors can cause large and sudden exchange rate movements regardless of domestic economic conditions. Supporting the use of the domestic currency as funding currency for operations in the domestic market would thus be an important element of reducing the potential instability caused by financial integration and currency internationalisation. 

Activities

In addition to last week’s workshop and public launch of the report, our findings have also led to intense and continuous dialogue with consultancy stakeholders and other policy makers; three workshops in Brazil with a wide range of policy makers, practitioners and academics; and a number of smaller workshops and conference panels.

For further information about these findings, including the costs and benefits and the compatibility of different types of currency internationalisation, you can read the report online. If you would like to get in touch regarding this research project, please email Research.LUBS@leeds.ac.uk