The euro, long the beneficiary of central bank reserve buying, may be seeing that support ebb and possibly reverse. If so, and all else being equal, downward pressure on the euro may mount at a time when the European Central Bank, struggling to avoid a third recession since 2008, will find this quite useful.
Global central bank reserves, at more than $12 trillion, are a massive force in setting the price of currencies and have a major impact in offsetting or magnifying monetary and economic policy. One of the big stories of the past 15 years has been the huge growth of global central bank forex reserves, particularly in China, which went from having very little at the end of the last millennium to nearly $4 trillion today.
That was pretty simple: when you have a current account surplus from profitable exports you do business in dollars and end up holding them.
After all 87 per cent of currency exchanges (which by definition involve two currencies) include dollars, showing its stunning dominance as an international means of exchange.
But, according to Stephen Jen of hedge fund SLJ Macro Partners, that exerted downward pressure on the dollar, as central banks then sought to diversify their reserves in order to hedge dollar risk. The euro was a beneficiary, at least up until the euro area crisis.
But though the euro’s share of reserves declined from 2008 to 2011, much of that was a decline in value rather than a decline due to reserve management. That may be changing.
“In contrast to the pattern pre-2009, central banks have stopped accumulating euro reserves beyond what has been needed to offset the variations in euro-dollar [prices],” Jen and SLJ colleague Joana Freire write in a note to clients. “The risk going forward could be an outright divestment from the euro by central banks.”
Now while euro area officials would quail at any suggestion that central banks are retreating from the Eurozone single currency as a stable source of reserve value, that seems unlikely to be what is happening. Coming as it does at a time when the ECB is struggling to make sufficiently stimulative policy, a slowdown in reserve buying of the euro could be extremely useful, at least to the Eurozone.
There have already been some signs that private investors, seeing the writing on the wall in terms of monetary policy and growth, have turned euro-negative, sending it from $1.36 in July to $1.26 now. The euro may also suffer, and the dollar benefit, as emerging markets, which drove the last 15 years of reserve accumulation, see their economies change.
Not only has China said it wants to accumulate less in reserves, but many expect the (arguably) largest economy in the world to now be in an epochal shift from an export-based to a consumption-based economy. That process, which may also be happening elsewhere in emerging markets, may imply that the very strong growth of central bank reserves may slow, or even begin to reverse.
Jen also argues that Chinese investors will export capital, as they seek to diversify, something which, if allowed, will lessen reserve accumulation by the PBOC.
Now remember, countries which export profitably end up holding dollars. In turn they sell some of these dollars in order to have more diversified reserves, buying euros, sterling and yen, among others. That process has been huge, with global reserves growing by something on the order of $10 trillion in a decade and a half, as globalisation deepened.
It has also, you could argue, exerted a steady, subtle downward pressure on the dollar, as reserve managers sell dollars to buy other currencies. To the extent that we think that whole process will slow or reverse, then we should expect it to drive the value of the dollar up and the value of the yen, sterling and particularly euro down.
And of course what is a boon for the ECB, giving them a bit of needed stimulus, could end up being a headache for the Federal Reserve, depending on how thing play out.
A rising dollar will crimp demand for US exports and be a wet blanket on inflation pressure from imported goods. That might be OK if the US is doing reasonably well, but will pose an issue if its economy slows.
On the whole, the very long period of huge reserve growth has been marked by bubbles, crashes and mismanagement. The transition will be tricky, but may well be for the good.
