Foreign exchange intervention and reserve accumulation – especially among emerging market and developing countries – has been a hot button issue for many years now. It came to the fore when the then Federal Reserve Chairman Alan Greenspan voiced concern about the “conundrum” taking place in world financial markets, especially in US fixed income instruments.
At a time when the Fed was raising interest rates, long term US yields simply would not rise. This was because various global central banks were intervening to prevent their own currencies from appreciating. After buying dollars against such currencies as the Korean won or Brazilian real, these central banks would then buy US Treasuries and thereby force US yields down.
Right now, the Fed is not worried about allowing US yields to rise. Indeed, the central bank has committed to keeping interest rates low until sometime in 2015.
But when the time does come for the Fed to engineer higher interest rates, these sizable global reserve assets – calculated by the International Monetary Fund as $10.9 trillion ($6.1 trillion allocated and $4.8 trillion unallocated) – will remain a force to be reckoned with and a potential powder keg.
Comments by US Treasury Secretary Jack Lew, made in mid-April before the IMF’s International Monetary and Financial Committee, suggested that the United States remains concerned about inappropriate FX intervention and the hoarding of currency reserves.
Lew stressed that the IMF “must do its part in implementing rigorous surveillance over members’ exchange rate policies, which remains at the core of the Fund’s mandate.”
“While the IMF’s legal framework for surveillance has been updated over time, one constant is that the IMF staff have been tasked to closely monitor for protracted large-scale, one-way foreign exchange interventions, as well as large and prolonged current account deficits or surpluses,” he noted.
“There continues to be a need for a more rigorous emphasis on excessive foreign exchange intervention and reserves accumulation in bilateral surveillance. We encourage all IMF members to be transparent with respect to foreign exchange intervention and reserves composition,” Lew said.
The problem with the IMF’s Currency Composition of Official Foreign Exchange Reserve (COFER) data is that not all countries report the breakdown of their reserves. A key country like China reports total reserve holdings, but not the countries where these monies are held. Saudi Arabia, with foreign exchange reserves estimated by the CIA’s World FactBook to be $626.8 billion at the end of 2012, is another such non-reporting country.
A big shift in allocation, say from the United States to the euro zone, or vice versa, could have an effect on both the FX rate, and the country’s fixed income market. That’s not to mention the havoc that could be wreaked if a country such as Australia or Mexico, with a far smaller bond market but investment grade credit status, fell out of favour for some reason and reserve assets shifted.
The latest official reserve data, released on 11 April, show that Chinese reserves swelled $130 billion to $4.4 trillion in the first quarter of 2013.
A day later, the US Treasury Department released its semi-annual foreign exchange report, “on-time” for the first time since April 2009. The Treasury stated that China was not an FX manipulator (Japan and South Korea were also singled out), but that “the RMB remains significantly undervalued, and further appreciation of the RMB against the dollar and other major currencies is warranted.”
The Treasury acknowledged the 10% yuan gains seen since June 2010, when China lifted the peg versus the dollar (it had been pegged during the financial crisis), and noted that when adjusted for inflation, the rise was even greater.
“Because inflation in China has been higher than in the United States over this period, the RMB has appreciated more rapidly against the dollar on a real, inflation-adjusted, basis, appreciating 16.2 percent since June 2010 and about 44.8 percent since China initiated currency reform in 2005,” the FX report said.
Still, the US Treasury stated that the Chinese yuan or renmimbi was not being allowed to rise in line with freely traded markets and had been stemmed by increased intervention, starting in January 2013.
“China’s intervention continues to be overwhelmingly ‘one-way’, with the central bank intervening far more heavily to keep the RMB from appreciating than it does to keep the RMB from depreciating, and ‘sterilized,’ with the impact on the domestic money supply largely neutralized through purchases of local currency debt and the reserve requirement ratio,” the Treasury noted.
More importantly, the country “should commit to participation in the IMF’s Special Data Dissemination Standard and COFER databases befitting its status as the world’s second-largest economy,” the report said.
The Treasury also noted that China has transferred sizable reserve assets to its sovereign wealth funds, with the China Investment Corporation (CIC) the largest. “China’s state sector as a whole – including the PBOC, state-owned banks, and CIC – holds roughly $4 trillion in foreign currency assets,” the FX report said.
China is not the only country to have super-sized reserve assets. The IMF’s External Sector Report of 2012 noted on page 24 that as of 2011, Brazil, India, Russia, and Thailand, in addition to China, all have reserve holdings well above the 100% to 150% suggested adequacy range.
Unless these reserve assets sizably shrink, which is unlikely to happen unless the dollar rises sharply and these central banks decide to intervene selling dollars – improbable unless the benefit of a weaker currency’s effect on exports is overshadowed by fear of global investor exodus – the lion’s share of these assets will make their way into developed country bond markets and potentially act to cap rates.
According to the latest CityUK data in Bond Markets 2012, the US bond market was the world’s largest as of March 2012, accounting for 33% of the value of bonds outstanding, followed by Japan at 14%, and the UK and France with around 6% of the share each.
The current concern is that Japanese investors, whether the Mrs. Watenabes of the country, Japanese pension funds or insurance companies, will move abroad in light of the Bank of Japan’s plan to buy large quantities (Y7.0 trillion-plus, or about $71.7 billion) of Japanese government bonds each month. This is separate from Japan’s own foreign currency reserves, which totalled $1.254 trillion at the end of March, but remain largely invested in domestic assets.
Expectations of these Japanese investor outflows have pushed US Treasury yields lower in recent sessions, along with German Bund yields, with the US and Germany seen as receiving the bulk of these outflows.
Analysts suggest that these flows will take time to materialise, and stress that in the scheme of things, depending upon the trajectory of US Treasury yields at the time, even if all $72 billion came directly to the US, these flows may or may not have a meaningful effect.
That said, a perfect storm of global investor inflows, coupled with safe-haven flows, could push US yields lower than the Fed would like. Or conversely, when the Fed does seek to actively raise rates, these flows may act as a roadblock to slow the process down. The same can be said of the European Central Bank, which often has its finger on the trigger to raise interest rates to combat inflation.
World central banks, especially the Fed and ECB, are sitting on a powder keg and they know it. That is why US Treasury Secretary Lew is pushing for transparency, at the very least.