Soft Currency

In the foreign exchange market, the currencies of different countries have different characteristics and values. According to their relative strength, they can be divided into hard currency and soft currency. Soft currencies refer to currencies with low credibility and stability, which are usually only used in the home country or region and are susceptible to exchange rate fluctuations and devaluation. For example, the South African Rand, the Russian Ruble, the Saudi Arabian Riyal, the Malaysian Ringgit, etc. Soft currencies are typically characterized by high inflation, high interest rates, high risk premiums, and low international reserves.

How to Trade with Soft Currency?

Choose the Right Settlement Method

Depending on the transaction type and risk tolerance, you can choose cash transactions, letter of credit transactions or collection transactions. Generally speaking, cash transactions are the safest but least flexible method, letter of credit transactions are safer but more expensive methods, and collection transactions are more flexible but risky methods. 

Use Forex Contracts to Manage Exchange Rate Risk

A foreign exchange contract refers to a foreign exchange transaction in which the buyer and seller exchange and settle two currencies on the same delivery date. Foreign exchange contracts can be designed into spot transactions, forward transactions or foreign exchange swap transactions according to transaction needs. You can use foreign exchange contracts to lock in future exchange rates, thereby avoiding losses caused by exchange rate fluctuations or making profits from exchange rate changes.

Choose the Appropriate Quotation Method

According to different currency characteristics, you can choose direct quotation or indirect quotation. Direct quotation is based on the local currency to express the foreign currency exchange rate. For example, the RMB quotation USD/CNY 7.0 means that one U.S. dollar is exchanged for seven yuan. Indirect quotations express local currency exchange rates based on foreign currencies. For example, the euro quotation is EUR/USD 1.1, which means that one euro is exchanged for one dollar. Generally speaking, direct quotations are more common, but in some countries or regions that use soft currency, indirect quotations may be used to show the strength of the local currency relative to hard currency.

Pay Attention to Various Factors that Affect the Exchange Rate

In the foreign exchange market, the exchange rate of soft currency is often affected by a variety of factors, including supply and demand, market sentiment, political events, economic crisis, government intervention or restrictions, etc. These factors may cause the soft currency exchange rate to fluctuate significantly or continue to depreciate. Therefore, small and medium-sized foreign trade companies need to pay close attention to changes in these factors and adjust their trading strategies and risk control in a timely manner.

Pros and Cons of Trading with Soft Currency

Pros

• Reduce settlement risk. Principal swaps through OTC clearing companies or real-time payment and settlement systems can achieve simultaneous settlement of different currencies and avoid settlement risks caused by time differences or counterparty defaults.

• Synergies with cross-currency swap settlement. FX contracts and cross-currency swaps are two commonly used FX hedging instruments that allow for more effective risk management by offsetting and hedging each other.

• Ease credit limit restrictions. Bearing credit risks through central clearing institutions can reduce credit limit and term constraints between banks and other market peers, and increase transaction flexibility and efficiency.

• Deal with wrong-way risks. Wrong-way risk refers to the risk that occurs when the credit risk of a counterparty is negatively correlated with the credit quality of the counterparty. For example, when the counterparty's credit rating declines, the currency it holds may also depreciate. Wrong-way risk can be effectively eliminated through central clearing. 

Cons

• Exposed to exchange rate risk. Since the exchange rate of soft currency is often unstable, it may fluctuate significantly or continue to depreciate due to factors such as market supply and demand, political economy, etc. For companies that engage in cross-border trade, this may result in reduced revenue or increased costs, affecting profits and competitiveness.

• Difficulty exchanging for other currencies. Due to the low creditworthiness of soft currency and the small demand for it in the international financial market, it is difficult to convert it into other currencies, especially hard currency. This will increase the time and cost of transactions, and will also limit the company's liquidity and investment opportunities.

• Subject to exchange controls. In order to protect the stability of their own currencies, some countries or regions that use soft currency will implement foreign exchange controls and restrict the free exchange, circulation and transfer of foreign exchange. For companies conducting cross-border trade, this may cause transaction inconvenience and risks, and also affect the decision-making autonomy of the company. 

Difference Between Hard Currency and Soft Currency

Creditworthiness and Stability

Hard currencies refer to currencies that have a high degree of credibility and stability, are generally widely accepted and used, and are able to maintain or increase their purchasing power. Soft currencies refer to currencies with low credibility and stability, which are usually only used in the home country or region and are susceptible to exchange rate fluctuations and devaluation.

Inflation and Interest Rates

Hard currencies are typically characterized by low inflation, low interest rates, low risk premiums, and high international reserves. Soft currencies are typically characterized by high inflation, high interest rates, high risk premiums, and low international reserves.

Liquidity and Convertibility

Hard currency has a high degree of liquidity and convertibility in the international financial market. It can be freely converted into other currencies or gold and is not subject to foreign exchange controls. Soft currency has low liquidity and convertibility in the international financial market and is difficult to convert into other currencies or gold. It may also be restricted by foreign exchange controls.