Final straw for decade-long FX reserve accumulation

July 29, 2012

RECORDER REPORT

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July 2012 may well prove a watershed in the decade-long policy of hard-currency reserve accumulation by China and other developing countries that has helped transform the global economy and world investment since the turn of the millennium.

Vanishing returns on scarce "safe" sovereign debt - where US Treasury bill rates are the lowest since the 1800s and many European bills and bonds are selling with negative rates - and Monday's threat to Germany's top-notch credit rating could be the final straw for central banks managing $10.4 trillion of these national savings and emergency hard cash buffers.

Ratings firm Moody's' cut to the outlook on Germany's triple-A mark comes almost one year after rival Standard and Poor's cut the United States' top rating by one notch. Now no sovereign of the four currencies that make up more than 90 percent of world hard cash reserves - the United States, Germany and the other 16 euro zone members, Britain and Japan - has a AAA rating with a stable outlook from all three major credit ratings firms.

Yet with everyone from banks, ultra-conservative investors and central bank reserve managers all now insisting on capital preservation and ease of liquidation in choosing foreign assets or rebuilding balance sheets, the scramble is intense for the dwindling pool of so-called safe assets that the International Monetary Fund reckons may shrink by another $9 trillion by 2016.

So pity the poor reserve manager who seems to have been left holding the baby after five years of crisis. Returns are now less than zero on sovereign bills and bonds even as they lose triple-A credit quality; commercial bank deposits and securitized assets have long since been deemed too risky; and alternatives such as corporate or emerging market debt are simply too few to absorb the scale of demand. "The whole issue of abysmally low or negative returns, negative costs of carry and rising credit risk will almost certainly impact on reserve manager thinking," said Simon Derrick, head of currency research at Bank of New York Mellon.

While management of national savings, reserves or windfalls will continue in different forms, such as sovereign wealth funds, the rationale for deliberately accumulating ever larger amounts of hard currency reserves via fixed or semi-fixed domestic currency pegs - as was the case in booming China for more than a decade - is shifting significantly. The net result over time may be both higher currency market volatility, especially for developing countries, but also potentially higher borrowing costs for governments of the main reserve currencies, where the US dollar, euro, British pound and Japanese yen currently command roughly 62 percent, 25 percent, and 4 percent each, respectively, of total reserves.

China, by far the largest holder of hard currency reserves and already steadily loosening its dollar/yuan peg as well as slowing the pace of its reserve growth, surprised in the second quarter this year by showing a slight decline in reserves to $3.24 trillion from $3.31 trillion. In tandem, the yuan is more than 1 percent weaker against the dollar in 2012 to date. Further exchange rate flexibility and capital account liberalisation may well be the final step to ending the relentless increase in loss-making stockpiles altogether.

While governments of the four main reserve currencies plus Switzerland provide sovereign debt securities worth almost $40 trillion, the governments of Australia, Canada, New Zealand, South Korea, Brazil, Russia, South Africa, Turkey, Mexico, Poland, Hungary, Malaysia, Indonesia, Peru, Colombia, the Philippines collectively provide just $5 trillion of paper. What's more, reserve management in hard currencies has been heavily loss making for years for China and other managers who effectively remove yuan and local currency created during currency intervention by selling local banks' debt securities that are increasingly higher yielding than rock bottom "safe" assets where they bank the hard cash.