Q&A on the Reserve Currency Status of the USD
April 21, 2008
By Stephen Jen | London
Summary and Conclusions
We maintain our view that the dollar will likely retain its hegemonic reserve currency status for the foreseeable future. In this note, using a Q&A format, we address some specific questions investors may have regarding this issue. Question 1. Are Central Banks Aggressively Diversifying from USD Assets? There are different ways of thinking about this question. The most popular data that investors refer to are the IMF’s COFER quarterly data on the currency composition of the world’s reserve holdings. (Not all IMF member countries that report the aggregate reserve positions also report their currency compositions. Specifically, as of end-2007, the COFER data on currency composition cover only 64% of the world’s reserves.) According to these data, the USD’s share in total world foreign reserves has declined from 72.7% in 2001 to 63.9% as of end-December 2007, with developed economies having a higher (69.4%) concentration of USD holdings than developing countries (60.7%). During the same period, EUR’s share rose from 17.6% to 26.5%, with developing economies having a higher exposure to the EUR (29.0%) than developed countries (22.2%). Thus, the short answer to this question is ‘yes’, there has indeed been a decline in the USD’s share in the world’s official reserve holdings in the past few years. While this may be the short answer, it is not a complete answer. First, to conclude that the world’s central banks have been diversifying out of USD, one would also need to address the question of how the swings in the exchange rates may have affected the COFER currency shares. Using the annual data from the IMF on the volume and the value changes in reserve holdings in different currencies, we find that, with the exceptions of 2002 and 2005 – the years when the dollar strengthened – in the aggregate, central banks have actually bought disproportionately more dollars when the dollar depreciated, and bought disproportionately more euros when the euro depreciated (in 2005). In other words, more than 100% of the change in the currency composition of reserves reported by the COFER database can be explained by changes in the exchange rate, and, in fact, central banks have been ‘buying low and selling high’ in order to preserve some benchmark targets. The USD’s share seems low mainly because of the weak dollar, and its share was high in 2002, similarly, due to the strong dollar then. Indeed, we first pointed out the volume-value effect back in 2006, in “G10: Official Reserves a Source of Stability, Except in 2002”, FX Pulse, September 28, 2006. We now observe that this pattern has persisted. Second, while at 63.8%, the USD’s share in total reserve holdings may be low, certainly lower than the 72.7% registered in 2001, the dollar’s share actually declined to below 50% in the early 1990s. Thus, the decline in the USD’s share is unremarkable, from a longer-term perspective, despite the angst. Question 2. Will the Euro Challenge the Dollar’s Hegemonic Reserve Currency Status? Again, the answer to this question is not straightforward. There are several considerations in thinking about this question. Some academic works on this matter have taken a quantitative approach to calculating the currency share of official reserves that can be explained by fundamental variables such as the size of the economy in question, the rate of return and the liquidity in the financial markets of the reserve currency. On these measures, the EUR seems to be a very serious challenger to the dollar. Further, if the UK joins the EMU, many of the liquidity and market size measures for the EMU could surpass the size of the capital markets of the US. For example, the combined market capitalisation (bonds and equities) of the EMU and the UK in 2007 was US$37.4 trillion, representing 30% of the world. The same metrics for the US would be US$43.5 trillion and 35%. Having said the above, there are two reasons to believe that the EUR will not be able to supplant the USD’s hegemonic reserve currency role, even though the former can take some market share away from the USD. (Similar to car racing, it may be easy to catch up to another car. Passing it is another story.) First and foremost is the advantage of being the incumbent. Increasing returns to scale are immensely powerful. In our previous writings on this topic, we have used the analogy of languages, that English is the preferred international language not necessarily because it is superior to other languages, but because it is ‘in the lead’ as the most widely spoken foreign language in the world, and so it will most likely remain in the lead as more people around the world learn English in order to communicate with the rest of the world. The positive characteristics of other currencies will need to be much superior to those of the dollar to offset this ‘incumbent advantage’. We have previously mentioned the experience of how the dollar managed to surpass the GBP as the leading international currency in the early 1940s, even though the US economy and trade surpassed those of the UK in the 1920s. While one could argue that such a lag may not be so long this time, our point is that Euroland is unlikely to become so much bigger – in terms of both the economy and asset markets – than the US in the way that the US became bigger than the UK. The second consideration is related to the first, that the issue is really not the US versus Euroland. Rather, we need to ask what currency standard the rest of the world (that does not have a reserve currency) will have. Specifically, Asia, in our view, will likely remain on a dollar standard for a very long time to come. Even though few Asian currencies are now pegged to the dollar, most of the international transactions are still conducted in USD, reflecting the less-than-full convertibility of most currencies and the preference of Asian countries for invoicing and settling trade and transactions with each other in US dollars rather than each other’s currencies. For example, we hear people comment that Asia now trades as much, if not more, with Euroland than with the US. Statements like this one miss the point, because Asia trades with itself in dollars, and 43% of Asia’s trade is with other Asian countries. Question 3. What Is the Prospect of the CNY as a Challenger to the US Dollar? It is a probable, not just a possible, scenario that China’s economy will exceed the size of the US economy in our generation. This makes the CNY, or a form of Asian currency unit centred on the CNY, a much likelier challenger to the USD. Bottom Line We maintain our view that the dollar will likely remain the dominant international currency for the foreseeable future. Available data do not unambiguously support the view that central banks in the world have been aggressively diversifying from the USD. While assets denominated in EUR have experienced a sharp improvement in liquidity and depth since the establishment of the EMU, Asia and other parts of the world continue to rely on the USD as the medium of exchange and unit of account. The ‘incumbent advantages’ that the dollar enjoys will be difficult to overcome. The most likely challenger to the USD will be the CNY or an Asian currency unit centred on the CNY. But the key precondition is that Asia manages to develop its financial markets.
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A Sibling Rivalry: Central Banks versus SWFs
April 21, 2008
By Stephen Jen | London
Summary and Conclusion Investors should be aware of an emerging rivalry between central banks and SWFs (sovereign wealth funds). Nobody likes to have money taken from them; even fewer enjoy having hundreds of billions of US dollars taken from them. The inter-departmental rivalry within countries has various implications that are important to investors. Mounting ‘Inter-Agency’ Tensions As many may know, government agencies often have objectives and preferences that may not be perfectly aligned. In the general discussion about the emergence of SWFs, investors should be sensitive to the fact that most of the capital of SWFs – particularly those in Asia – is capital that would have ended up in the official reserves, which are usually controlled by the central banks of the countries in question. To many central banks, establishing SWFs to conduct investments in ‘risky’ assets is not a compelling proposition, as many of these central banks already have well-trained investment professionals and well-honed risk-management frameworks in place. At the same time, some of the younger SWFs have encountered short-term setbacks, as some of their early investments have suffered paper losses. It will be critical, in this inter-agency tug-of-war between central banks and SWFs, that the latter are able to generate higher investment returns, in order for them to justify further transfers from the central banks. In response, or in anticipation, central banks are likely to raise their risk profile in order to maximise their own investment returns, so as to raise the hurdle for further foreign asset transfers to SWFs. The Example of the Swiss National Bank (SNB) The SNB has been a leader among central banks in diversifying its foreign exchange holdings into equities and corporate bonds, away from sovereign bonds. The National Bank Act (NBA), enacted in 2004, permitted such a change in investment strategy. At end-2007, the SNB had around CHF127 billion worth of foreign reserves, CHF50 billion of which is held in foreign exchange reserves, CHF35 billion in gold, and the rest in claims from CHF transactions and other assets. While the bulk (61%) of the SNB’s foreign exchange reserves is still held in government bonds, its corporate bond and equity holdings are substantial – 25% and 12% of the total, respectively. While there has been diversification across assets, since the introduction of the NBA in 2004, the SNB’s official foreign reserves are still held in very few currencies: EUR (47%), USD (28%), GBP (10%), JPY (10%), and CAD and DKK (5% combined). (However, within the G10 currency space, the SNB has dramatically reduced its exposure to USD assets (from 80% of its reserves in 1997 to 28% now), and increased its exposure to EUR (from 18% exposure to the legacy European currencies in 1997 to 47% now) and GBP (from 0% in 1997 to 10% now).) Implications of This ‘Sibling Rivalry’ Since this move towards greater risk-taking by central banks is, at this point, still a prospective trend, rather than an established trend (though some central banks may have already begun to take more investment risk), some of our thoughts are speculative and suggestive, and not based on hard facts. • Thought 1. Japan, China and Korea may have already begun to invest their official reserve holdings differently. Anecdotal observations suggest that the reserve managers (not the SWF entities) in Japan, China and Korea are paying more attention to capitalising on shorter-term market opportunities. While we would not call this ‘day-trading’ by central banks, there seems to be more attention paid to shorter-term variability in the currency markets by Japan’s MoF, China’s SAFE and the Bank of Korea (BoK). All three are challenged by existing SWFs (CIC and KIC) or a prospective one (in Japan). The BoK may be much more active in ‘trading’ (rather than ‘investing’) to help repel demand for more transfers of its reserve holdings to the KIC. China’s SAFE faces a similar pressure from CIC. For Japan, the debate in the government on whether Japan should have its own SWF is intensifying. (We have written quite regularly on this issue, starting with Why Japan Should Have Its Own Sovereign Wealth Fund, July 5, 2007.) The MoF is also responding by being more mindful of shorter-term movements in its traditional investment domain, in order to maximise the ‘alpha’ of its reserve holdings. At the same time, at least one of these entities may have begun to invest in equities. For investors, it is reasonable and useful to assume that the SNB’s model will be broadly emulated. A 10-15% exposure to developed market equities for a country like Switzerland implies that countries like China, Japan and Korea could have much higher exposures because of the size of their excess reserves. (These are official reserves in excess of the need for liquidity purposes. We have looked at this issue, by considering import coverage and the Greenspan-Guidotti Rule. Please see Excess Official Reserves, July 12, 2007.) Indeed, investing some official reserve holdings in equities is not unorthodox, even though it may be unusual. In the guideline document issued by the IMF on balance of payments, it is noted, “Foreign exchange includes monetary authorities’ claims on non-residents in the form of ECUs, currency bank deposits, government securities, other bonds and notes, money market instruments, financial derivatives, equity securities, and non-marketable claims arising from arrangements between central banks or governments”. We thus expect more central banks to raise their exposure to developed market equities, partly to enhance their investment returns. However, we do not anticipate that reserve managers will move into private equities or real estate, or EM (emerging markets). In any case, given that emerging market economies are likely to have more than US$1.5 trillion in excess reserves, we are likely to see countries other than China, Japan and Korea going down the same path in deploying part of their official reserve holdings in equities.
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Not Wishful but Realistic: April Outlook Report Preview
April 21, 2008
By Takehiro Sato | Tokyo
New Leadership, New Stance In the April Monthly, which was released after the first MPM under the new leadership, the BoJ downgraded its economic assessment. The series of hedge clauses added to the bank’s assessment under the former leadership were cleared in one go under the fresh initiative. Among others, disappointing March Tankan figures seem to have prompted the BoJ to end its bullish stance. With the bank’s Monthly being a warm up for the next Outlook Report (due out on April 30), a downgrade in the April Outlook Report is almost certain; the question is the severity of downgrade. In that sense, one key aspect of the upcoming Report would be if the BoJ’s F3/09 outlook for real GDP growth approaches a high-1%, close to the growth potential. Another focus is whether the bank will tone down its policy stance towards the normalization of interest rates. Our view is that the BoJ will reveal a reserved economic outlook and at the same time reverse its forward-leaning stance towards normalization. What’s New The board’s estimates for the economy/prices in the Outlook Report are defined as the integration of individual members’ forecasts. However, BoJ officials are likely to be having scrupulous discussions with each board member in preparation for the release of these figures. Thus, we believe that the median estimate can be interpreted effectively as the official view of the bank. Below, we focus our discussion on the median estimate. We expect the BoJ to slash its F3/09 economic growth outlook to a low-1%, below the growth potential. Meanwhile, the Report will contain the bank’s first projection for F3/10, which we think will predict a return to the growth potential. More specifically, we project +1.4% for F3/09 (+2.1% in the October Report) and +1.8% for F3/10. As for the core CPI rate, the BoJ will likely revise up its outlook for F3/09 to a low-1%. Meanwhile, the price outlook for F3/10, to be released for the first time in the Report, has little likelihood of making an impressive statement, as uncertainty over primary commodity prices including crude oil lingers. But we expect an even wider YoY margin due to the surge in food prices. Specifically, we project +1.3% (+0.4% in the October Report) for F3/09 and +1.7% for F3/10. Note that the temporary absence of two board members, including one deputy governor, should not affect the usual method of data disclosure (an estimate range containing all board members’ forecasts, an estimate range for the majority, and the median). As far as policy management goes, the BoJ has maintained to date that “given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan’s economy is to follow a path of sustainable growth under price stability”. With regard to the pace of rate hikes, its stance has been that “the bank will adjust gradually in accordance with improvements in the economic and price situation” (from the October 2007 Outlook Report). In other words, the basic attitude has continued to be one for a rate hike, even if only gradual in pace. That said, since the issuance of the previous Outlook Report at end-October, the financial turmoil has expanded throughout the globe. Money markets are still suffering the stress of liquidity pressures despite bountiful capital supply by the central banks. Given these changes in the environment, the biggest focus of the April Outlook Report is whether “raise” or “adjust” will still be mentioned at all. In light of the marked downgrade to the economic assessment in the April Monthly, we expect the BoJ to come to the conclusion that advocating a rate hike at this point would not be wise. The consequences should be a neutral outlook report on the policy front. Where We Differ from the Market Our rough calculations put real GDP growth for January-March at a mid-2% SAAR at least. The result is a higher base-effect for F3/09, to about +1.0pt (versus +0.4pt in our current official forecast); as our economic outlook assumes, this will make it difficult to keep growth at below +1% in F3/09. As such, it would not be preposterous for the market’s consensus on the BoJ outlook to be for growth on the order of the potential growth rate, in the upper-1% range. Conversely, if the bank’s outlook is in the lower-1% range, as we assume, this would send a bearish message that domestic growth in F3/09 is expected to be in only flat territory. Such a message would likely have market implications. Meanwhile, the core CPI hinges on the fate of the provisional gas tax, and is unfortunately a meaningless string of numbers without such assumptions in the BoJ’s and market’s outlook. It is imperative to confirm this even in analyzing the BoJ’s forecast. Incidentally, the core CPI does entail upside risk to mid-1%Y towards the end of 2008, if the impact of additional increases to the resale price of imported wheat by the government from April gradually kicks in and the provisional gas tax is reinstituted from May. Another round of wheat import price hikes is on tap for October too. This is raising the risk that the inflation rate will land at about a high-1% towards the end of 2009 if the provisional gas tax is reinstated. Our projection for the bank’s outlook is based on the assumptions above. The bank’s evaluation of exogenous factors in this area is a point to watch. Our focus will be on the downward effect from such cost-push inflation on real income. Poorer terms of trade are expanding trade losses, and price growth will also drag down real income. The resulting loss of purchasing power in the overall economy obviously has ramifications for monetary policy. Policy Implications Logically, the BoJ would have a rate cut option by toning down its economic outlook and policy stance in the Report. However, political wrangling unexpectedly derailed the process of nominating the new governor, which has paralyzed any chance of a proactive rate cut for now and left our outlook for a cut in peril. For the following reasons, the reactive rate cut option is increasingly likely to be preserved for critical situations, however. For starters, Governor Masaaki Shirakawa seems optimistic on the economy in the immediate future, claiming resiliency to any major downfall from external shocks. Second, the equity markets already factor for a rash of downward revisions in full-year F3/08 corporate earnings and F3/09 guidance, calling for sharp earnings declines. Markets have also been emboldened by expectations on policy action by overseas authorities to prop up the credit market. Third, the salvo of liquidity measures by the US fiscal and monetary authorities has calmed both the foreign exchange and credit markets. Likewise, we suspect that the new governor, given how his nomination transpired, is unlikely to promise anything to the Fukuda administration on the future direction of monetary policy. The chances of an early rate cut are disintegrating, as a result. On the other hand, Mr. Shirakawa has also stressed that the BoJ would act flexibly when necessary in the event that downside risk were to materialize. While a rate cut in April-June is now becoming a long-shot, the second half of the year remains a possibility depending on the path of the stock market. Risks Risk factors lie in economies both at home and abroad, as the new BoJ governor has repeatedly asserted, and are more to the downside still. The outlook on prices is an upside risk, meanwhile, regardless of whether the provisional gas tax is reinstated. All of these areas could crimp growth in real incomes. The Outlook Report is therefore also likely to emphasize downside risks. In fact, the BoJ’s March Monetary Policy Meeting minutes revealed several members saying that worsening terms of trade had reduced the economy’s capacity to generate income by depressing corporate profits and wages. One board member added that this was already evident by a fall in the growth rate of real gross domestic income (GDI). Indeed, October-December second preliminary GDP showed both real GDI (+0.2%Q) and real gross national income (GNI; +0.4%Q) paling in comparison to the flashy headline (+0.9%Q). The odds are that this will be the case in January-March GDP as well. Although the new BoJ governor has not indicated that the economy is particularly vulnerable to external shocks, the sluggishness of income growth makes the economic outlook far from robust.
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