Strategy Slowing EM outflows to support euro, Scandi markets

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1 Jan-5 Jun-5 Nov-5 Apr-6 Sep-6 Feb-7 Jul-7 Dec-7 May-8 Oct-8 Mar-9 Aug-9 Jan-1 Jun-1 Nov-1 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Investment Research General Market Conditions 2 October 215 Strategy Slowing EM outflows to support euro, Scandi markets We estimate that EM central banks sold USD 143bn worth of reserves in August, making it the largest fall in EM FX reserves on record. China accounted for USD 16bn of the USD 143bn. Over the coming months, we expect EM FX reserve outflows to slow given rising credibility of China s new exchange rate system while the economy bottoms out. Overall, therefore, EM FX reserve outflows and rebalancing should slow. In August, we estimate that if EM reserve holders mechanically rebalance their FX reserves it would imply USD 28.1bn of EUR/USD selling and USD 5.7bn selling of other currencies including SEK, NOK and DKK. Going forward, slowing EM FX reserve rebalancing should support Scandi markets and lower core euro yields. EUR/USD selling from EM reserve managers should slow in coming months, supporting our medium-term bullish view on the cross. EM reserve outflows our estimates Since China s devaluation on 11 August, there has been substantial focus on EM FX reserve outflows and how they are impacting global FX and fixed income markets. In this piece, we look at how changes in FX reserve flows are impacting our core euro and Scandi markets. Below, we focus on the 13 largest EM FX reserve holders (see footnote under Chart 1). Chart 1: EM FX reserves have fallen marginally 8 EM FX reserves Adjusted EM FX reserves* EM crisis 6 Lehman crisis 4 2 *Adjusted by holding the FX rates constant since January 25 which provide an estimation of the change in FX reserves ex. valuation changes. Countries included are Mexico, China, Taiwan, South Korea, India, Saudi Arabia, Brazil, Russia, Thailand, Turkey, Indonesia, Poland and Malaysia. Global Head of FICC Research Thomas Harr, Phd thhar@danskebank.dk Important disclosures and certifications are contained from page 6 of this report.

2 Feb-5 Aug-5 Feb-6 Aug-6 Feb-7 Aug-7 Feb-8 Aug-8 Feb-9 Aug-9 Feb-1 Aug-1 Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Strategy These account for around 93% of total EM FX reserve holdings. We adjust for valuation effects, i.e. the fact that as the USD strengthens, the USD value of FX reserves falls. To adjust for valuation effects, we use the IMF COFER data for Emerging and Developing Economies. By Q1, EM central banks held 63.59% of their reserves in USD, 19.6% in EUR, 5.% in GBP, 3.43% in JPY, 2.24% in CAD, 2.4% in AUD, and 4% in other currencies. China s currency composition is not known. However, for simplicity, we assume that it is in line with the EM average. One can guesstimate China s USD share from the US s TIC data but the challenge is that China also likely buys through offshore centres like the Bahamas, Bermuda and the Cayman Islands. Hence, in any case estimation of China s currency composition from US TIC data is also inaccurate. In Chart 1, we show EM FX reserves measured in USD and adjusted for valuation effects. EM FX reserves have risen consistently over the last decade with only a brief stabilisation due to the global financial crisis. Based on where EM FX reserves came from, EM FX reserves potentially have a lot more room to fall. In Chart 2, we show the change in adjusted FX reserves, i.e. estimates of the actual FX intervention. We note that FX outflows have accelerated in recent months. August saw the largest drawdown in FX reserves over the last decade. We estimate that EM FX reserves managers sold USD 143bn worth of reserves with USD 16bn of this by China. In Figure 3, we show our estimates of the monthly change in FX reserves for China. We believe the pressure on EM markets and currencies will remain given downside risks to Chinese growth, a likely US rate increase in December and a lot of structural and cyclical issues in a number of large EM economies like Brazil and Russia. However, China is, as always, by far the most important EM country. How much the People s Bank of China (PBoC) continues to intervene will depend on two factors. Chart 2: EM FX intervention in August was the largest on record Change in adjusted EM FX reserves Lehman crisis EM crisis First, China s growth outlook and fear of a hard landing and second, the credibility of its exchange rate system. We believe that China will continue to be forced to intervene substantially in the coming months but likely less so than in August. The Chinese authorities recent success in narrowing the CNH-CNY spread following the devaluation and early signs that CNH now trades more expensively than CNY for the first time since the 11 August devaluation suggest that outflows are about to slow. In addition, the CNY will over time become more free floating which will necessitate less currency 2 2 October 215

3 Feb-5 Aug-5 Feb-6 Aug-6 Feb-7 Aug-7 Feb-8 Aug-8 Feb-9 Aug-9 Feb-1 Aug-1 Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Strategy intervention. We expect that growth in China is close to a cyclical bottom as a range of extensive stimulus and a recovery in housing should lead to a moderate recovery in Q4. Over the medium term, we believe that CNY is close to fair value and hence do not see the case for the PBoC having to continue to intervene massively to defend the CNY. Other central banks in Brazil, Turkey, Russia, Indonesia and Malaysia are likely to continue to have to intervene to mitigate local currency depreciation. But they are tiny compared to China in terms of FX intervention both because their absolute levels of FX reserves are much smaller and because their exchange rate systems are more flexible. Market implications What then are the implications for FX and fixed income markets? Here a number of assumptions are needed. First, we assume that the reserve losses themselves, i.e. the selling of USD and buying of local currencies, do not affect global FX or fixed income markets. In theory, this would be true if all the pressure on a given currency were driven by USD-related capital outflows. This may be a decent approximation in the case of China where a large part of the capital outflows appear to be related to repayment of USD-denominated bank liabilities. Secondly, we assume that the intervention is generally occurring through selling of USD and buying of local currencies which, for the most part, is true for the EM countries we are considering. Finally, the assumptions regarding the rebalancing of FX reserve holdings are crucial. In Q1 15 the EUR share of EM FX reserves fell to a multi-decade low of 19.6%. Clearly, this can partly be explained by the fall in the EUR. Chart 3: China has been driving the EM FX outflows 15 1 Change in adjusted China FX reserves 5-5 Lehman crisis EM crisis Meanwhile, the JPY share and the share of other currencies reached multi-decade highs of 3.83% and 4% respectively of EM reserve holdings. If we assume a mechanical rebalancing, EM reserve holders sold USD 28.1bn of EUR and USD 5.7bn of other currencies just in the FX intervention in August. Clearly, FX reserve holders do not mechanically rebalance and it is not clear that the current weights are binding for EUR or for other currencies. In fact, it appears likely that the EUR weight is not binding and the targeted EUR weight is in fact higher. The same goes for other currencies which includes SEK, NZD, HKD, NOK, SGD, KRW and DKK. 3 2 October 215

4 Strategy Starting with the EUR implication, the EUR weight can increase either by USD FX intervention, which is occurring now, or a higher EUR. A need arises from EM reserve intervention to sell EUR/USD but it is difficult to predict the size. Moreover, the need of EM central banks to sell EUR/USD is likely to decline gradually as depreciation pressure on the CNY abates and/or China allows a more flexible exchange rate. In recent months, EM reserve flows have likely been dominated by equity FX hedging flows as falling European equities have driven asset-managers buying of EUR/USD to maintain fixed FX hedge ratios. That was clear during the peak of the market sell-off in late August. These equity-related hedging flows have likely dominated EUR selling by EM FX reserve managers. Over the medium term, any negative EUR impact from FX reserve rebalancing should dissipate and support our medium-term constructive view on the EUR. To our knowledge, there is no detailed data for non-eurozone official holdings of euro govies. But it is likely that EM reserve holders are primarily invested in core or semi-core markets. According to the US Treasury, as of June 214 almost three-quarters of foreign official holdings of US long-term debt securities were in maturities up to five years. We believe that EM reserve holders are also primarily invested in relatively short-dated euro govies. During August, German yields rose around 8bps despite a fall in 5y5y inflation expectations in the eurozone of 1bps which is an indication that EM reserve rebalancing affected core euro govies. Another sign is the collapse in German asset swap spread where EM FX reserve flows have driven cash selling. Slowing EM FX reserve outflows suggest core euro yields should edge lower in coming months Chart 4: EM central banks should have sold USD 28.1bn EUR in August Amounts to be sold in USD if full rebalancing, adj. outflow in August EUR GBP Other JPY CAD AUD In terms of Scandi markets, EM reserve managers indicated in a recent IMF report that they are considering increasing their share of other advanced currencies like the CHF, CAD, AUD, NZD, DKK, NOK and SEK. (See Survey of Reserve Managers: Lessons from the crisis, WP/13/99). Clearly, the AUD and CAD are the most important here where liquidity of bond markets is a major concern for FX reserve managers. But the SEK, DKK and to a lesser extent NOK are also part of some EM FX reserve holders mandates. EM FX reserve outflows have likely on the margin been a negative factor for Scandi FX and fixed income markets in recent months. In the coming months, EM FX reserve rebalancing should be less of a negative for Scandi markets as EM FX reserve outflows slows. 4 2 October 215

5 Strategy Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The author of the research report is Thomas Harr, Global Head of FICC Research. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates This publication is updated on a weekly basis. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. 5 2 October 215

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