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4.2.4 Capital Control

The final issue we are going to discuss, capital control, is one that is peculiar to emerging markets and is not a matter of degree (shorter versus longer maturity, small versus large bid-offer spread, etc.), but only of being present there.

A government has the ultimate tool to control FX rate in its own currency: by being able to print money in that currency it can always offer a two-way price in the currency market. This two-way price is rather a bottomless one way since this tool works very well in one direction, devaluation. In the other direction, the government's tools do not differ from those of any other big market players (i.e., it needs to have large foreign reserves to buy back its own and make it appreciate).

In the case of small countries, whose currencies' total amount is significantly less than the one of larger developed ones, there is sometimes the fear that a powerful external player might be able to manipulate the currency in the same way that the government would. For small countries the fear is usually of devaluation; for large, export-driven countries like China, the fear can be the opposite, that is, of their currency appreciating too much.

An example of curve inversion for a) Ukraine; b) Kazakhstan.

FIGURE 4.4 An example of curve inversion for a) Ukraine; b) Kazakhstan.

The answer to these concerns is capital control. To exercise capital control means to forbid the trading of a certain currency outside the currency's home country. This entails the creation of an on-shore market (in the currency's home market and open only to locals) and an off-shore market open to foreigners. It also entails, as a consequence, the creation of nondeliverable instruments, instruments dictating that, where they prescribe a payment in the protected currency, the actual settlement should occur in another currency (usually USD).

The most common types of instruments are nondeliverable FX forwards where the MTM of the trade, that is, the difference between the realized FX rate and the expected one at the beginning of the trade, is settled in the foreign currency only. Since we have seen in Section 2.2.3 that, through the interest rate parity, FX forwards are closely linked to discount factors, this mechanism has a profound impact on the interest rate market and creates a mirror on-shore, off-shore market for interest rates as well. Some of the more developed protected markets also have nondeliverable cross currency swaps, where the cash flows of the leg in local currency is settled in the foreign one (usually USD).

Figure 4.5 shows quotes for nondeliverable FX forwards premia for Chinese Renmibi (CNY). Let us consider the one-year points, whose mid value in pips is – 500 (negative). By using

to obtain the one-year value for the discount factor in CNY, we hnd a value of 1.00102 resulting in a zero rate bps. Not only is the value puzzling for being negative but it is also in clear contrast to the value found in Figure 4.6, which shows the fixings for the SHIBOR, the Chinese LIBOR equivalent (Shanghai Interbank Offer Rate). We have said at great length how the rates implied from FX forwards are conceptually very different from LIBOR, but they should still be in the same order of magnitude, as they both in the end represent some cost of borrowing. In this situation the difference is enormous considering we are comparing a small negative rate with one– we are focusing on the one-year SHIBOR rate–that is fixed at more than 5%. The reason for this difference lies in capital control. SHIBOR rates are the rates at which Chinese banks lend to each other: it is a market closed to foreigners. The zero rate we have implied from the nondeliverable forwards is one that is open to foreigners.

Let us state immediately (and this should alleviate the concern caused by the sight of negative rates) that the implied negative rate is purely fictitious

FX forwards premia for Chinese renmibi (CNY). Source: Thomson Reuters Eikon.

FIGURE 4.5 FX forwards premia for Chinese renmibi (CNY). Source: Thomson Reuters Eikon.

SHIBOR fixings as of September 8, 2011. Source: Thomson Reuters Eikon.

FIGURE 4.G SHIBOR fixings as of September 8, 2011. Source: Thomson Reuters Eikon.

and it is used either for illustration purposes (as we have done here) or for operational ones. (In some trading systems one needs to visualize the rate that leads to the correct forwards, in other words, and paraphrasing the famous expression, the bizarre number that needs to be plugged in, in order to give the right value.) As we have stated many times, FX traders trading forwards are simply concerned about cash flows in different currencies and they are indifferent to and uninterested in the interest rate implied from them.

With capital control, probably the most peculiar of emerging markets characteristics, we conclude the brief exposition of the issues one might meet when dealing with less developed markets. We shall now observe how these issues can impact in particular the borrowing and lending of a development institution.

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