Imagine you have a widget to sell, something that helps pick apples. You offer the widget to a bunch of apple farmers, who think, yes, very useful, and offer you a price for it. Then you go to another set of orange growers and offer the same widget, and they’ll say, well we could use it, but its a different shape, and offer you a price half of what you got before (I’m assuming away the ability to arbitrage).

In essence, that’s the problem facing central banks with currencies traded both onshore and offshore – while the product’s the same, the market players are different and you’ll get different prices as a result.

In Malaysia’s case, we have the regulated onshore market and an unregulated, over-the-counter (OTC), non-deliverable forwards (NDF) market offshore (here’s the wiki entry on NDFs) where BNM has no jurisdiction. More than half of trading on the NDF market is speculative. That in itself is not a problem: speculators provide liquidity and help towards better pricing. The onshore market isn’t entirely clear of speculators either, though typically this is done as an adjunct to real money flows, rather than a goal in itself.

Therein lies the problem, as I see it, from BNM’s perspective. You have an onshore market that is primarily real money flows, and an offshore market which is largely speculative. Some of the players are the same (that’s actually a fairly strong requirement for the offshore market to exist), but in times of stress, there will be a price wedge driven between the two markets which would otherwise ordinarily be arbitraged away. In essence, because the two markets operate with different players and different purposes, offshore price volatility is much higher than it should be.

Issue number two, one I’m hearing from many sources, is that foreign investors preferred to hedge via the NDF market for the simple reason that its easier to do. Hedging your Ringgit exposure onshore (essentially selling Ringgit in the forward market for US dollars) required some documentary evidence of the underlying Ringgit assets. When markets are moving, as happened in November, putting documentation together for a submission is not what you want to have to do – the time wasted costs money, and the bigger the market move, the bigger the hit you take.

But using NDFs is problematical – because NDFs are an OTC market, banks have to take the other side of the trade from clients. If someone is hedging a Ringgit exposure or speculating on a Ringgit decline (sell Ringgit for USD), the bank dealer has to take the opposite position (buy Ringgit for USD). This isn’t a problem if there’re two-way flows, and the spread is small – banks don’t need to risk their own capital, since they can offset the flows into and out of Ringgit positions either internally or through the interbank market or through the onshore market.

But in times of market stress, with client demand essentially going one way, banks have no choice but to take on the risk. The only way to mitigate that risk is by aggressive quoting – basically pushing quotes to clients beyond where you think you might have to take a loss. Contrast that with the onshore market which always has some real money/real economy flows (trade receipts for example). That means that there’s always some FX demand going against the flow of the market, reducing the risk of carrying an open position.

The upshot is that the offshore NDF market will always be more volatile than the onshore market, whether its spot or forwards, and will always overshoot any notion of fair market pricing. Moreover, because the offshore market operates 24/7 while the onshore market keeps regular office hours, there’s a tendency for the onshore market to be influenced by quotes offshore, even though offshore market quotes are driven as much by the flaws in its microstructure than a fair balance of supply and demand for a currency.

Which of course brings us to the new measures announced last week (excerpt):

Statement by Financial Markets Committee Initiative to Develop the Onshore Financial Market As part of the strategy to broaden and deepen the Malaysian financial markets, the Financial Markets Committee, in collaboration with Bank Negara Malaysia (BNM), would like to announce several measures intended to enhance the liquidity of the foreign exchange (FX) market with effect from 5 December 2016: Liberalisation and deregulation of the onshore ringgit hedging market To provide greater flexibility for market participants to manage foreign exchange (FX) risks, residents (including resident fund managers) may freely and actively hedge their USD and CNH exposures up to a limit of RM 6 million per client per bank. A one-time declaration of non-participation in speculative activity would suffice.

Resident and non-resident fund managers can now actively manage their FX exposure up to 25% of their invested assets. To qualify for this arrangement, registration with BNM would suffice.

To broaden accessibility of foreign investors and corporates to the onshore FX market, offshore non-resident financial institutions may participate in the Appointed Overseas Office[1] (AOO) framework which will be accorded additional flexibilities on ringgit transactions. These flexibilities include FX hedging (own account/on behalf of client) for current and financial account based on commitment, opening of ringgit account (book-keeping) and extension of ringgit trade financing. Streamlining treatment for investment in foreign currency assets Resident entities with domestic ringgit borrowing are free to invest in foreign currency assets both onshore and abroad up to the prudential limit of RM50 million. Residents without domestic ringgit borrowing shall continue to enjoy flexibility of investing in foreign currency assets both onshore and abroad up to any amount. This gives equal treatment for residents with ringgit borrowings investing in foreign currency assets whether in the onshore or offshore market. Incentives and treatment of export proceeds Exporters can retain up to 25% of export proceeds in foreign currency. They may hold higher balances with approval from BNM to meet their obligations in foreign currency. Payment by resident exporters for settlement of domestic trade in goods and services is now to be made fully in ringgit. All ringgit proceeds from exports can earn a higher rate of return via a special deposit facility. The special deposit facility for ringgit proceeds will be offered to exporters via all commercial banks and receive a rate of 3.25% per annum. This facility will be offered until 31 December 2017 subject to further review. Foreign currency arising from conversion of export proceeds will be used to ensure continuous liquidity of foreign currency in the onshore market. In addition to the newly announced hedging measures, exporters are also able to hedge and unhedge up to 6 months of their foreign currency obligations.

You can essentially read this as a tale of two parts – liberalisation for capital flows, and tightening of rules for exporters. The first few measures basically address the issue of making it easier to hedge or take positions in the onshore market. While still subject to limits (financial stability and FX asset liability mismatches are still considerations), it does bring allow for greater flexibility to trading FX onshore without getting bogged down in paperwork. There’s also the closing of a small loophole in the present rules.

These are really long term measures that won’t have any immediate impact on the current level of the MYR. It will take time for all parties involved to understand the new regime, than adjust their internal systems and procedures to adapt to it. But the end result should be a deeper and more liquid onshore market.

The second, on export proceeds, are because exporters were de facto taking positions on currency movements – essentially keeping nearly all their sales proceeds in US dollars over the last five years. That meant the Ringgit exchange rate hasn’t benefited from Malaysia’s status as a trade surplus economy, while closing off much of the opportunity for BNM to rebuild its FX reserves. Forced conversion wouldn’t really be my first choice of policy option, but I honestly can’t think of anything else that would be as effective.

Before anybody screams “Capital Controls!”, neither forced repatriation nor forced conversion are all that unusual for emerging markets. The previous regime was in fact relatively liberal. The change will cause some pain for exporters (conversion costs, especially if they have to reconvert to pay off imports), but to offset that, they’ll have been sitting on substantial FX translation gains all this while, none of which will be touched by the new rules.

Since existing deposits have been “grandfathered” (no need to convert), the effect on the exchange rate will come purely from the balance of flows from here on. That roughly translates to a net RM4-6 billion in additional demand for Ringgit a month, or RM200-300 million a day. That helps, but isn’t a whole lot relative to the USD7.9b daily volume of transactions on the onshore FX market (for the month of November). Again, this doesn’t address the current weakness in the Ringgit, but the cumulative impact should be to help create a deeper and more liquid onshore FX market.

When – not if, but when – the US Dollar starts reversing, I don’t think anybody will be complaining anymore.