A new report by the Monetary and Economic Department of the Bank for International Settlements, economists argue that the offshore banking system needs to be revisited. Offshore accounts can be beneficial for the emerging markets economies, but pose a threat to financial stability in the home countries. However, its possible to manage these risks, the BIS economists says.
“Expansion of central bank balance sheets amid fiscal expansion in the world’s major economies has, in some views, called into question the major currencies’ reliability as stores of value.”
Dong He/Robert McCauley
The offshore markets intermediate a large chunk of financial transactions in major reserve currencies such as the US dollar. McCauley and He argue that the emerging market economies who are interested in seeing some international use of their currencies, offshore markets can help to increase the recognition and acceptance of the currency, while still allowing the authorities to retain a measure of control over the pace of capital account liberalization.
However, the development of offshore markets could pose risks to monetary and financial stability in the home economy which need to be prudently managed, the two economists points out.
Adding: “The experience of the Federal Reserve and of the authorities of the other major reserve currency economies in dealing with the euro markets shows that policy options are available for managing such risks.”
Securing The Dollar Dominance
According to the report, a significant portion of the international use of major reserve currencies, such as the US dollar, takes place offshore.
In particular, when non-US residents use the US dollar to settle trade and make investments, they do not transact onshore through banks and in financial markets in the United States.
Rather, they concentrate their transactions in international financial centers such as the euro-dollar market in London.
“In fact, one may argue that, without the offshore markets, the US dollar would not have attained the dominant position in international trade and payments that it occupies today,” the report says.
“We show that non-US residents reveal a strong preference for doing their dollar business outside the United States. That is, they tend to deposit US dollars in banks abroad and to buy US dollar bonds issued by non-residents outside the United States (and probably to hold them in European depositories as well).”
Judging from the US dollar, global investors prefer to transact in a particular currency through the offshore markets.
Non-US residents, private and official alike, keep the bulk of their US dollar deposits outside the United States and invest disproportionately in US dollar bonds issued by non-US residents.
“The payment flows associated with these accounts and investments ultimately pass through bank accounts in the United States, just as payment flows associated with non-bank financial intermediaries in the United States ultimately pass through banks in the United States. While the US authorities put in place capital controls from the late 1960’s until the early 1970’s, they never impeded the flow of payments through US banks to allow the settlement of offshore trade and investment transactions. Offshore markets in a currency can flourish if offshore financial institutions are able to maintain and to access freely clearing balances in the currency with onshore banks. In other words, non-resident convertibility of the currency is allowed at least for overseas banks. Once this condition is met, both long and short positions in the currency can be built up offshore even without a wholesale liberalization of capital account controls by the onshore country authorities. If offshore banks do not have free access to clearing banks kept with onshore banks, then offshore markets can still exist, though in a more limited fashion, through non-deliverable contracts,” Dong He and Robert McCauley writes.
Threat To Stability
The development of offshore markets in a given currency poses several challenges to a central bank’s responsibility for maintaining monetary stability.
An offshore market in a given currency can increase the difficulty of defining and controlling the money supply in that currency. Equally, an offshore market in a given currency can pose a challenge to measuring and controlling bank credit.
“Offshore activity in the currency might also affect the shape of the yield curve or the exchange rate. If the central bank sets the overnight (or some other short-term) rate with a view to targeting inflation and growth, then policymakers would have to factor these effects into their inflation forecasts and set the short-term interest rate appropriately.”
The BIS economists makes the following concluding statements:
* “For emerging market economies that are interested in seeing a larger share of their international balance sheets denominated in their own currencies, offshore markets can help to increase the recognition and acceptance of the currency among exporters, importers, investors and borrowers outside the country. This process can begin (but not end) while substantial capital controls are still in place, allowing the authorities to retain a measure of control over the pace of capital account liberalization.”
* “The development of offshore markets could pose risks to monetary and financial stability in the home economy which need to be prudently managed. The experience of the Federal Reserve and of the authorities of the other major reserve currency economies in dealing with the euro markets shows that policy options are available for managing such risks. The lesson to be learnt is that the home authorities need to be alert to such risks, and factor in the additional influence of offshore markets on domestic monetary conditions and financial risks when making monetary and financial policies.”
* “Would the global financial system benefit from a wider array of internationalized currencies with offshore markets? The offshore dollar markets described in the first part of this paper, dominated by non-US banks, issuers and investors, have limited the rents flowing to the United States from the global use of the dollar, at least by comparison with the heyday of sterling. So the issue may be less distributional and more whether greater pluralism in international finance is conducive to global financial stability. The long-standing arguments regarding the stability of leadership/hegemony, on the one hand, and pluralism, on the other, need to be revisited in the light of the experience with the dollar shortage during the financial crisis.”
Related by the Econotwist:
- Should You Consider Offshore Banking? (mint.com)
- Hong Kong looms as offshore market for yuan: Soros (reuters.com)
- How To Set Up An Offshore Bank Account (coedmagazine.com)
- Bancor and American Sovereignty (nowpublic.com)
- Long march to renminbi convertibility (ft.com)
- Missing links (ftalphaville.ft.com)