Offshore Currency: What It Is & How It Differs From Onshore

What is Offshore Currency?

In the international financial market, offshore currency is a frequently mentioned term. An offshore currency is a currency deposited and traded outside its country of issuance and is not subject to the financial laws and regulations of the issuing country. Therefore, we refer to offshore currencies as “free currencies.” For example, a US dollar deposit held in a Singaporean bank is an offshore US dollar, a British pound deposit is an offshore pound, and a Hong Kong dollar deposit is an offshore Hong Kong dollar. We call financial markets like London and Singapore, which handle offshore currency lending and trading, offshore financial centers (Offshore Market or Offshore Center).
Let’s take a specific currency as an example: a US dollar deposit in a US bank is an onshore US dollar, while a British pound deposit is an offshore pound. The domestic currency lending market in the issuing country is called the onshore financial market (On-shore Market).
It is worth mentioning that an offshore currency refers to a currency used for deposit, loan, and trading activities outside its country of issuance (foreign bank deposits in the domestic currency). Physical cash of a country’s currency circulating abroad is not considered offshore currency.

Why Do Offshore Currencies Exist?

Offshore currencies are created by a combination of economic and political factors. For instance, if a European country is unwilling to deposit its US dollars in the United States due to US financial market regulations, it may deposit them in Europe instead, creating an offshore currency market—the Eurodollar market.
Taking the currency of a country with foreign exchange controls as an example: the currency circulating within this country is subject to foreign exchange controls, with both individuals and businesses facing quotas and approval processes for converting to US dollars. The exchange rate between the domestic currency and the US dollar is also controlled by the central bank. However, the domestic currency circulating outside the country is largely unrestricted and adjusts freely based on market changes. In this situation, the exchange rate of the onshore currency against the US dollar is generally stable and less prone to significant fluctuations. In contrast, the exchange rate of the offshore currency against the US dollar is susceptible to short-term factors and can experience large swings.
When we talk about offshore currencies, we often think of the offshore Renminbi (RMB), which directly affects our interests. To date, the RMB maintains a managed floating exchange rate system. Correspondingly, in 2010, policy began to favor the establishment of an offshore RMB market. The offshore RMB market has now been developing for over a decade and is primarily traded in Hong Kong, Macau, and global currency markets. The split between onshore and offshore RMB began in 2010 when the government started allowing foreign companies to use RMB instead of US dollars for domestic investments, marking the official internationalization of the RMB. This approach was chosen to encourage exports, thereby creating a balance of payments surplus for the economy.

What is the Significance of Offshore Currencies?

Let’s continue with the RMB as an example: if a foreigner does business in China and earns RMB, they need government approval to convert their RMB into their home currency or US dollars. This can create policy uncertainty in the trade environment. In this scenario, the free convertibility of offshore RMB can solve this problem. Foreigners can freely exchange currencies in these offshore markets without worrying about their RMB being “locked” due to an inability to convert.

However, the exchange rate of offshore RMB is influenced by market conditions and is vulnerable to shocks from the international financial market, especially changes in the risk appetite of overseas investors. During times of turbulence in the international financial market, a significant spread often appears between the onshore and offshore RMB exchange rates. This is when arbitrage trading occurs. The investment opportunities and tools created by the offshore market for its participants will also largely determine the level of development of the offshore market.

The Relationship Between Offshore and Onshore Currencies

Although in theory the exchange rate of an offshore currency is not subject to intervention by the issuing country’s central bank, it is closely linked to the onshore currency. There are three main channels that connect the exchange rates of offshore and onshore currencies:

• Cross-border trade settlement for import and export enterprises: When the offshore currency exchange rate is lower than the onshore rate, cross-border export enterprises tend to conduct transactions in the offshore market. This is because the same US dollar income can be exchanged for more of the domestic currency in the offshore market. When export enterprises sell US dollars and buy the domestic currency in the offshore market, it causes the offshore currency to appreciate, narrowing the exchange rate spread between the two.
• Investor sentiment: If the onshore currency has been appreciating for a considerable period, the offshore currency becomes an object of pursuit for investors. Consequently, the offshore currency’s exchange rate will be significantly higher than the onshore rate during this appreciation period. In the event of a country’s economic deterioration, offshore investors’ confidence in its economic growth may decline, leading to a depreciation of the offshore currency exchange rate. Confidence in the currency in the onshore market will also change, creating a mutual influence.
• Non-Deliverable Forward (NDF) transactions: This is a type of forward foreign exchange transaction and is considered an offshore financial derivative. Due to regulations governing onshore and offshore financial institutions, they cannot directly engage in arbitrage with each other. However, arbitrage operations can be conducted in the NDF market. This arbitrage activity causes the exchange rates of the offshore and onshore currencies to converge.

Trends

As nearly half of the world’s countries begin the process of “de-dollarization,” the internationalization of the RMB is starting to accelerate. Although true internationalization of the RMB is still a long road ahead, a sound offshore RMB market will lay a solid foundation for this journey.