Since the end of the Cold War, foreign exchange has been a barometer of globalization's progress. As both cross-border trade and capital flows increased, lifting incomes and living standards along with them, currency trading volumes grew fivefold to average more than $4 trillion in daily transactions last year.
But now there are signs that this rapid growth has stalled. For the sake of the global economy, that's a worry.
Central banks overseeing six of the world's busiest foreign-exchange markets released the results of their semiannual surveys Monday and disclosed that overall average trading volumes were down by about 5% in April from a year earlier. In North America and the U.K., spot market trading in the euro-dollar pair was off by 40% and 24%, respectively.
Market professionals painted the decline as the byproduct of a general reluctance to invest internationally. Investors, nervous about what lies in store for the global economy, have taken to keeping their money at home, they said.
It is the latest manifestation of a breakdown in international investor confidence, a malaise that first took root after the collapse of Lehman Brothers in September 2008. This pernicious condition later seemed to resolve itself, but it never really went away and simply resurfaced with the onset the euro-zone debt crisis.
When repatriation of capital occurs on this scale, the danger is that other nationalizing trends aren't far behind. The souring investment climate spills over into real economic performance, as seen in Wednesday's dismal manufacturing reports from around the world, and the same instinct to avoid having one's money offshore can give rise to a similarly defensive posture in trade policy. Thankfully, few countries are following the lead of Argentina, which has adopted strict import and foreign-exchange controls in response to a mounting domestic crisis, but its all-out lurch into extreme protectionism offers a cautionary tale.
To understand both the vulnerabilities we face and the way out of this trap, let's take a deeper look at forex volumes over the past few years.
Back in April 2009, the same central banks reported a 25% year-on-year drop in turnover, the first real sign of a downturn in trading volumes in two decades. There's no secret to what caused it: a plunge of similar magnitude in world merchandise trade and an accompanying evaporation both in cross-border merger and acquisition flows and in international portfolio investments, all products of the paralysis in global finance triggered by the Lehman collapse.
But then currency trading had a Lazarus-like recovery. By the time the Bank for International Settlements conducted its more comprehensive triennial survey of world-wide forex volumes in April 2010, total turnover had recovered completely and was running at $4 trillion a day, well up from $3.3 trillion three years earlier. The subsequent semiannual surveys showed the total turnover rising all the way to an average $4.7 trillion a day by October 2011, according to extrapolations from the six central banks' results by BIS analyst Morten Bech. It looked as if the great expansion in global financial transactions had completely reasserted itself.
And yet, worryingly, the underlying drivers of forex growth did not see a similar recovery. World trade took much longer to get back to its pre-Lehman state and, as J.P. Morgan foreign-exchange analyst John Normand points out, portfolio flows still haven't done so while merger-and-acquisition activity is currently wallowing at its lowest level in a decade.
So, what drove the forex resurgence in 2010 and 2011? According to various BIS reports, a key driver was the rapid expansion in both high-frequency currency trading and retail forex trading, both of which are typically divorced from any underlying asset-based transaction. There are far fewer tangible global economic benefits from this speculative activity than there are from trade or portfolio from fixed investment flows. And the latest reports show that its growth is too flimsy to make up for the trading volumes lost when those real money flows ebb.
Nonetheless, the latest reports do offer glimmers of hope.
While trading in the major currencies saw big declines, spot-market activity in emerging-market currencies continued to grow over the past year. That's irrefutably tied to ongoing advances in the real money investment outlook for those countries.
What's more, because cash trading in these currencies is typically limited to their domestic markets, there's an opportunity for far greater investment and trade flow growth if emerging-market governments liberalize their capital accounts and internationalize their foreign-exchange markets. Consider the opportunities that will arise once China fully internationalizes the yuan.
What's most needed globally, however, is freer trade. If advanced-country governments want to boost economic growth and put forex traders back to work at their embattled financial institutions, reviving a push for a new world trade agreement should be their top priority.—Michael Casey is managing editor for the Americas at DJ FX Trader, a foreign-exchange news service from Dow Jones Newswires and The Wall Street Journal. His new book on the global financial system, "The Unfair Trade," was published in May. Write to Michael Casey at Michael.J.Casey@dowjones.com.