from Follow the Money

Reserve growth has slowed, but it probably hasn’t stopped

September 6, 2008

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For the past several months, almost all global reserve growth has come from China and the oil exporters. These also are countries that tend either not to report their reserves data quickly (China formally releases data once a quarter) or that channel their oil surplus into sovereign funds that in some cases don’t report any data at all.

More recently, China added another curve ball: a growing share of the growth in China’s foreign assets seems to be coming from the state banks, and the increase in those assets isn’t disclosed along with the growth in its reserves. The small ($11 billion) increase in China’s reserves in June is misleading: the state banks likely met the 100 bp rise in their reserve requirement by holding dollars -- and the central banks "other foreign assets" rose sharply.

It so happens that those countries that report data more rapidly are no longer adding to their reserves. The falls in reported reserves in August reflect valuation changes – a euro isn’t worth as many dollars as it used to be. But they also reflect significant sales of dollars by countries. South Korea and Russia are the most prominent cases.

This has produced a set of stories -- including this one by the FT’s Peter Garnham -- that argue that: "growth in FX reserves has stalled as the dollar has staged a broad-based rally since hitting a record low against the euro on July 15."

My sense though is that the data for August that has been released so far paints a somewhat misleading picture of the global story. Why?

1) Oil prices have fallen, but at $110 barrel they remain well above the price oil exporters need to cover their import bill. That implies the oil exporters are continuing to run a large current account surplus and that, barring large capital outflows (as in Russia), they are still adding to the funds at their central banks and sovereign funds. Ballpark, this should generate $500 billion or so in official asset growth annually, or about $40 billion a month. If $20 billion left Russia, that still implies $20b in net asset growth. Some will be in sovereign funds, but some will show up in reserves. It just will come from a lot of countries that don’t report data quickly (or at all).

2) China is still running a large current account surplus and it is still attracting net FDI inflows (in part because investment outflows have slowed following some initial losses). Say China is running a $350b current account surplus (remember, lower oil prices help China) and attracting $100-150b in FDI inflows. That would imply about $500 billion in official asset growth in China in the absence of any hot money inflows, or about $40b a month. Once you adjust for hike in the reserve requirement that is more or less what the June data showed. And we don’t have any formal data for July or August yet. It is possible that significant “hot” outflows cut into this total, but that would be a bit at odds with the ongoing tightening of inflow controls. I expect continued positive growth, just not at the extraordinary pace of earlier this year.

And indeed, that seems to be exactly what the PBoC’s renminbi balance sheet -- which has data on China’s foreign asset growth for July -- shows.

Of course, something important did change recently. Some significant countries are selling their existing holdings of dollars to support their currencies, which wasn’t the case until recently. Dollar sales often can lead to knock-on euro sales. If, for example, Korea sells dollars to buy won, it will then sells some of its euros for dollars to rebuild its dollar holdings just a bit. This keeps the dollar share of its portfolio roughly constant.

Actually, if past patterns -- hold -- and they may not, central banks would sell slightly fewer euros than might otherwise be the case to "rebalance" their portfolio even as they run down their dollar holdings, as the euro’s own slide is working to keep their portfolio close to its currency targets.

The FT’s article on changes in reserves also doesn’t quite get the "reserve diversification" story right.

Garnham -- drawing on the lot of the work of London based currency analysts -- argues that emerging economies have been diversifying their reserves over the past few years, and in the process putting downward pressure on the dollar. The argument starts by noting that "Data from the International Monetary Fund show developing countries’ central banks hold about 60 per cent of their reserves in dollars. The remainder is held in euros, sterling and yen." That isn’t quite right. We don’t actually know what “emerging economies” have been doing: The emerging economies that are adding the most to their reserves do not report data to the IMF. I suspect that countries that do not report actually have a higher dollar share, bringing the overall total up. No matter.

The FT then argues:

By diversifying some of their new reserves into other currencies, rather than keeping all their intervention proceeds in dollars, central banks have compounded the weakness in the US currency in recent years.

Emerging economies have been selling dollars for euros to meet their portfolio targets as their reserves grew, and faster reserve growth has meant bigger absolute sales. That sometimes is taken to mean "diversification." But if diversification means lowering the dollar share of reserves, those emerging economies that report data to the IMF have not been diversifying. Not after 2003.

The dollar’s share of reporting emerging economies’ reserves was 61.6% in q4 2003 and 60.9% in q4 2007, before slipping a bit more to around 60% at the end of q1 2008. The dollar fell over that time period. So a disproportionate share of the growth in these countries reserves had to go toward dollars to keep the dollar’s share of their reserves constant.

Consider this: the IMF’s data indicates that those emerging markets that do report data held euro 498.7 billion in euro-denominated reserves at the end of 2007, and euro 498 billion of euro denominated reserves in q1 2008. In other words, they were net sellers of euro during a period when the euro rose from 1.46 to 1.58. They added $89b to their dollar reserves over the same period. I wouldn’t exactly call that diversification -- and it certainly didn’t put pressure on the dollar.

The dollar’s overall share of total reserves has fallen, but that is almost entirely because the increase in the reserves of reporting emerging markets has been far faster than the increase in the reserves of the industrial countries. Reporting emerging markets have a lower dollar share than the industrial countries. As reporting emerging economies came to constitute a higher share of the total reserves, the dollar’s share of the total fell.

That isn’t a very dramatic story, but it is the story that fits the data best. The industrial countries have reduced their dollar share just a bit – but only a bit. Jamie McGreever of Reuters gets this right.

Those emerging economies that report data have tended, since the end of 2003, to buy proportionately more dollars when the dollar is under pressure to keep the dollar’s overall share of their rising reserves constant. Thus -- I would argue -- they have tended support the dollar not weaken it.

In my view, the correlation between the dollar’s weakness against the euro and reserve growth reflects reflects not diversification (i.e. fast reserve growth drives dollar weakness, as central banks sell dollars) but rather the greater pressure on many emerging currencies when the dollar was under pressure against the euro. The same market pressure that showed up in a weaker dollar v floating currencies showed up as higher reserves in countries with managed currencies. In other words, correlation, not causation. Things could change, but that is the story that seems to best fit the (limited) available data.

Here is what I think is happening now.

Over the past four quarters, the increase in official assets – central bank reserves as well as sovereign funds – has been truly extraordinary, and far larger than the current account surplus of the emerging world. Large capital inflows to the emerging world contributed to this strong growth.

Those flows have now reversed. Capital is now flowing out of a lot of emerging economies – Russia and Korea most obviously. That outflow shows up in falls in the value of key currencies as well as in falls in the reserves of some countries.

However, the scale of the outflows is still likely to be smaller than the size of the emerging world’s total current account surplus. That implies ongoing reserve growth, just at a slower pace.

One bit of supporting evidence: While the Fed’s custodial holdings fell last week, they were up a lot in August. Until there is a bit more supporting evidence in the Fed data, I would argue analysts should be careful not to claim that global reserves are falling.

A slowdown in the pace of growth: absolutely

An end to all growth: no

Not if Saudi and Chinese reserves are still growing.

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