from Follow the Money

Trouble in Tokyo ... and in London.

January 22, 2009

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Japanese exports are down. Way down. The 35% y/y fall in December is consistent with a brutal collapse in intra-Asian and global trade.

The yen, though, is up. Way up against some currencies. It recently approached a record high against the slumping pound.

The yen’s rise amid Japan’s slump is no doubt a source of concern at the Bank of Japan -- and the Ministry of Finance. No one right now really wants an appreciating currency.

It also has to be a bit of a concern to a few other central banks as well. At least to their reserve managers. Over the past several years, the pound has been a popular diversification play, taking a rising share of the world’s rapidly growing reserve pie.

In 2000, the IMF indicates that central banks that report detailed data to the IMF held a little less 4% of their reserves in pounds and around 6% in yen. By the end of 2007, the pound’s share topped 7% while the yen’s share had slipped to under 3%. Central banks didn’t like low yen rates, and the pound offered a bit of carry.

Some industrial counties (like the US) have long held a lot of yen, but the data from those emerging economies that report the currency composition of their reserves to the IMF is consistent with the global trend. If those emerging economies that do not report detailed data to the IMF acted like those that did, annual central bank purchases of pounds over the past several years have been in the $40 to $70 billion range. That is real money for an economy of the UK’s size.

The pounds share of the total slid a bit in q3 as the dollar and yen rallied, but that doesn’t mean that central banks were selling pounds. Those emerging markets that report data to the IMF bought $9 billion of pounds and sold $9 billion of yen in q3.

I will be curious to see if central banks continue to try to maintain their allocation to pounds now. Portfolio balancing, remember, means buying what is going down to keep its share of your portfolio constant. That could provide a bit of support for the pound.

If not, watch out. As Lisa Scott-Smith of Millennium Global Investments note (via Joanna Slater of the WSJ)

"The pound isn’t a natural reserve currency in the way that the dollar would be."

The fall in global reserve growth will cut into central bank demand for pounds no matter what. Countries like India that have long had a higher pound share are no longer adding to their reserves. Russia also liked the pound and its reserves are falling. If other central banks don’t buy pounds (and sell other currencies) as the pound falls to maintain the pound share of their portfolios, one big source of support for the pound will wither away.

And while low policy rates have, so far, been good for the dollar, they haven’t been good for the pound. Specializing in finance no longer seems like the sure path to national riches. Private demand for pounds has fallen even more rapidly than central bank demand. Equilibrium in the market will only be restored when the pound falls enough to make pound-denominated assets a bargain -- and when the current account deficit contracts enough to reduce the UK’s borrowing need.

Neither is pleasant.

It is even possible that the UK might end up experiencing something vaguely akin to the sudden stop in central bank purchases that Dr. Roubini and I theorized back in 2004 and 2005 might end up derailing the US expansion. A financial crisis that started the US has been, at least so far, bad for the pound and good for the dollar even though both of the large Anglo-Saxon economies looked kind of similar going into the current crisis. Funny that ....

p.s. I have no good contemporary data on central bank demand for pounds. The last IMF data point is from q3. If any reader has some market color, I am all ears ...

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