August 14, 2009
The market is missing a point about currency reserves
The FX market has become obsessed with central bank currency reserves and the prospect of diversification away from the USD. This has been fuelled by the recent meetings of global policymakers under the G20/G8 framework and increasingly candid comments on the subject from the largest currency reserve managers, namely China and Russia. Various suggestions have been put forward for an alternative global reserve currency, including expanded special drawing rights to incorporate the yuan and rouble. However, most of the proposals fail to provide a realistic alternative global reserve currency, with convertibility and liquidity the main sticking points. Moreover, it could be argued that recent comments from reserve managers are designed to put pressure on the US to moderate its policy response for fear that the extent of quantitative easing and the expansion of the Fed’s balance sheet could erode the quality of US assets. It may not be a coincidence that the Fed stopped the expansion of its balance sheet following Secretary of State Hillary Clinton’s visit to China in February.
But the market’s fascination with the subject of central bank reserves is likely to remain undiminished – purely because of the sheer scale of the amounts involved. The major central banks’ reserve managers control the largest pool of funds globally, suggesting that a sudden change in the weightings of currency reserves will have a massive impact on FX markets. Indeed, until recently there was an explosion in the pace of global reserve accumulation – the reserves of the major central banks reached $7 trillion last year, although this has since declined to $6.7 trillion according to BNP Paribas’ latest estimates. At one stage, reserve accumulation was running at a rate of over $50 billion a month. Therefore, it is not surprising that when the managers of the world’s largest currency reserves – Chinese FX reserves now exceed $2 trillion – start to discuss diversification, the market pays attention. We have argued in the past that much of this increase in global reserves was justified by the sharp increase in global trade, although perhaps not always in all the right currencies.
It is estimated that 62.5% of current global reserves are in the USD, down from around 66% seen in 2005, but still above the long-term average, estimated at around 55%. Meanwhile, on most measures, the EUR is still under-represented in global reserves, with a weighting of just 27%, although this has been creeping higher recently, up from 24% in 2005. A re-weighting of USD reserves towards the long-term average would generate around $500 billion of USD selling – which explains the market’s excitable reaction to the smallest suggestion of diversification. But, with this preoccupation with reserve diversification, the market is missing a possibly greater event.
While there is no doubt that a diversification of global currency reserves or the introduction of an alternative reserve currency would be momentous, they are far from being immediate risks. In our view the market is focusing on the wrong issue: the cyclical effects of reserve accumulation and management are already changing the dynamics of currency markets.
After all, it must be remembered that diversification – the selling of USD by central banks – has been taking place consistently during the entire reserve accumulation process. Just to maintain the current weightings of currencies, central banks have had to diversify a significant amount of their incoming reserves. Indeed, most reserves are accumulated in USD. The most prolific reserve accumulators have been the oil producers and, of course, China, implying that most of the $2.5 trillion of currency reserves accumulated over the past three years would have been in USD. So, assuming that 90% of all incoming reserves were in the USD, to keep the weighting stable during the massive reserve accumulation, central banks would have sold around $685 billion, far exceeding the amount that central banks would have to sell to diversify existing reserves back towards the long-term USD average.
This also goes a long way to explain the longer-term trend in USD. USD was in a sharp decline throughout the currency reserve accumulation over the past few years as central banks were consistent sellers of the USD to maintain weightings. More interestingly, the USD has rebounded strongly since the middle of last year. This rebound exactly coincides with the decline in currency reserve accumulation. In fact, the peak in EUR/USD chimes perfectly with the peak in global FX reserves in July 2008. Since then, global FX reserves have been in slipping, with the rate of decline continuing to accelerate. Global FX reserves are now falling at a rate of over $20 billion a month.
The global financial crisis and the resulting recession have had a significant impact on central banks’ behaviour when it comes to reserve management. The global slowdown has led to a collapse in global trade, which is consistent with the decline in currency reserves. The fall in the oil price is also taking its toll. Its 60% tumble from its peak, together with shrinking demand, suggest that there has been a dramatic reduction in the amount of petrodollars flowing to the producers. This is especially highlighted by the sharp decline in Russian reserves, which have shrunk by nearly $200 billion over the past year – although the central bank’s defence of the rouble has also made a significant contribution to that fall. Central bank reserves have also been in decline in the Middle East and Norway – indeed, in every region with the exception of Asia, where China is still accumulating them.
As the growth of reserves has slowed or reversed over the past year, central banks have had to sell less USD so that rebalancing may take on a whole new meaning. The decline in global trade and the fall in the oil price imply that central banks will have less need to sell USD, relieving some of the downward pressure on the currency. This will also reduce the need to diversify because many central banks are now experiencing this natural outflow of USD. Could it be that central banks will soon have to buy USD to maintain weightings?
So, while the market has been locked in discussion about the prospects of a new reserve currency to challenge the USD, the implications of a major cyclical downturn on currency reserves seems to have been overlooked. There is potential for the decline in reserve accumulation to have a far larger offsetting effect on USD than a 10% reduction in the currency’s weighting in reserves, which may or may not happen at some time in the future and depends on a suitable alternative being identified.
Ian Stannard is senior currency strategist at BNP Paribas.
Summer holidays