Emerging market central banks investment strategies: Tailwind for the euro?

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1 Economic Research Allianz Group Dresdner Bank Working Paper No.:38, Autor: Dr. R. Schäfer Emerging market central banks investment strategies: Tailwind for the euro? The euro has appreciated sharply against the USD since 2002 and most economists expect this trend to continue. A whole array of factors is behind this development. One element increasingly seen as driving down the USD is the investment strategy of central banks outside the big currency areas. An historical analysis fails to corroborate this. The currency composition of official reserve holdings (see table 1) has remained fairly constant in recent years. The data up to 2003 at least does not reveal any major shifts in the structure of reserves. Fluctuations in percentage shares mainly mirror exchange rate changes of major reserve currencies against each other. The same is largely true for the currency structure of deposits held with international banks 1. However, the fact that such changes did not materialize in the past does not necessarily mean that they can be ruled out in future as well. Given the economic size of the euro area the only currency which could challenge the dominant role of the US dollar is the euro. The euro has replaced national currencies whose individual role in international trade and finance was, with the exception of the DM, relatively small. Nevertheless, the time span since the introduction of the common European currency is still fairly short in monetary history terms. Moreover, the economic dynamism in emerging markets, above all in Asia, might result in displacements in worldwide economic gravity and therefore in shifts in the currency structure of official reserve holdings. 1 Bank for International Settlements (BIS): International Banking Statistics, December 2004, page A16/A17

2 Table 1: Share of national currencies in total official foreign exchange holdings (in %) a. all countries USD euro yen pound chf b. developing countries USD euro yen pound chf Source: IMF In the first part of this analysis we identify the major driving forces behind a greater degree in currency diversification in official reserves. In the second part we look at how relevant such motives might be in the case of selected emerging markets. Finally, we examine whether currency diversification could have a significant impact on the long-term development of exchange rates. Reasons to diversify official reserve holdings Like individual investors a central bank could try to maximize its profit from foreign exchange transactions. For instance, in order to profit from an anticipated revaluation of the euro against the USD it could convert at least part of its reserves into euro. Once the euro appreciates, the value of reserves expressed in USD would be higher. Correspondingly, the central bank s profit and the financial wealth held abroad by the respective overall economy have risen. As central banks are normally risk averse transactions driven by speculation are rare. However, if monetary policy in the country of the reserve currency is too expansive, driving the inflation rate up and the exchange rate down, central banks and private market participants shift assets into a more stable currency. This happened during and after the sunset of the Bretton Woods System, when the DM was increasingly preferred as an international 2

3 currency. Against this backdrop it is certainly an open question to what extent the huge current account deficit in the US scares private and official investors, including central banks, nowadays. A central bank could be tempted to shift reserves into a currency which is likely to appreciate against its own national currency. Given a successful transaction the value of reserves expressed in the domestic currency will rise. This enables the central bank to display a higher profit, which in most cases is transferred later to the ministry of finance in order to cover budgetary expenditure. Although most governments would certainly welcome such behavior, the overall economy has not become richer! A dollar or euro invested abroad remains what it had been before. However, a central bank could easily come under pressure from its government not to appreciate the domestic currency even in cases where it is necessary. For instance, the Taiwanese central bank was accused repeatedly by local politicians in the eighties of squandering the wealth of the economy. The revaluation of the new Taiwan dollar against the USD resulted in a lower value of reserves in the central bank s balance sheet and, therefore, in a book loss. International reserves represent claims against foreign economies. Therefore, reserves should be held in the currency of the country or economic area with which the bulk of trade and finance transactions is concluded. For instance, East European countries with particularly strong economic ties to West Europe should keep official foreign exchange holdings predominantly in euro. In Mexico, where business with US firms dominates the balance of payments, the reserve medium to prefer is clearly the USD. However, in most countries the currency in which foreign trade is handled is still the USD. For example, East Asian economies conduct at least the majority of transactions with other countries in the region in USD. And as many emerging market and developing countries export raw materials, which are traditionally quoted and invoiced in USD, the latter is the dominant currency in their balance of payments. Having the benefit of a huge common currency area it is likely that West European firms will increasingly insist on invoicing their foreign trade operations in euro in order to avoid foreign exchange risk. Thus, countries with a sizeable trade with the euro area will conduct foreign exchange transactions in euro and, as a consequence, convert part of their official foreign exchange holdings into the euro area s currency. Normally central banks refrain from publishing the currency structure of their reserve holdings. However, the exchange rate regime which a country pursues can also shed some light on its policy with regard to reserve allocations. In cases where the USD is exclusively used as a yardstick in exchange rate policy and/or the exchange rate is even fixed against it, it is fair to assume that the overwhelming majority of the reserves consists of USD-denominated assets. Conversely, when a country substitutes the USD with a currency basket, where the euro has also a certain weight, the central bank sooner or later converts part of its holdings into euro-assets. For example, the Russian government recently announced that a currency basket (weight 90% USD, 10% euro) would be used in future exchange 3

4 rate policy, replacing the USD as an anchor currency. It is therefore likely that the Bank of Russia s reserve holdings will comprise substantial euro-denominated assets as well. Most emerging market central banks have already begun to diversify foreign exchange holdings. In particular in those with exceptionally high reserve volumes, the foreign liquidity is held predominantly for investment purposes and less for the need to intervene in the foreign exchange markets in order to support the domestic currency s exchange rate sometime in the future 2. In this case the allocation of reserves may diverge from that based strictly on the exchange rate system. Therefore, even where the exchange rate is fixed against the USD, a diversification in reserves could make sense. Open foreign exchange positions in the balance of payments could also prompt a central bank to diversify foreign holdings. For instance, in the case of oil-exporting Arabian countries exports almost exclusively consist of oil and gas shipments, which are invoiced in USD. On the other hand, imports come predominently from the euro area, and are increasingly denominated in euro. When the euro appreciates against the USD, as has been the case in recent years, the countries are confronted with a severe deterioration of the terms of trade. In order to close the open foreign exchange position at least partially central banks could shift more reserves into euro. This would raise interest income in euro and help to offset the overweight of USD-denominated export earnings in the current account. A sensible solution to this problem would be to invoice raw material deliveries to Europe in euro. But in order to avoid a fragmentation of commodity markets this will take place very gradually, if at all. Will central banks increasingly prefer the euro as a reserve currency? The case of selected emerging market countries For countries which conduct the bulk of their foreign transactions with one big currency area, this question is fairly easy to answer. As already mentioned above it certainly makes sense for the new EU member countries to maintain the lion s share of their reserves in euro-denominated assets and to choose the euro as a yardstick for exchange rate policy. For some other East European countries, like Russia, for Latin American and East Asian emerging markets more sophisticated investment strategies with regard to the different currencies could be useful. Empirically it is difficult to establish for which countries it might be advisable to shift more reserves into the euro, as most central banks refrain from publishing the currency structure of reserves. For instance, in the case of a country with an increasing trade volume with the euro area it is possible that the respective central bank already maintains a significant part of reserve holdings in euro, so there is no need for further conversions. Moreover, data on the currency structure of bilateral trade flows is not available in the case of most emerging market countries. As an approximation, data on the geographic structure of exports and imports could be used, bearing in mind that, as already stated, most foreign trade undertaken between countries outside the US and the euro area is denominated in USD. 2 This may have been one of the driving forces behind a recent announcement of the Bank of Korea to raise revenues from foreign exchange holdings, see vwd internet service, 3/17/2005 4

5 Official foreign exchange reserves (USD bn, end 2004) Source: IMF Are there any clues as to which countries are likely to alter the currency structure of their reserves? In order to find some evidence we concentrate on emerging market countries with foreign exchange reserves exceeding USD 50bn at end A + indicates that the euro will probably gain in importance within the reserve composition. Furthermore, we use the EU as an approximation for the euro area in the analysis of foreign trade structures. This may overstate the role of Europe, since the UK, Sweden and Denmark are members of the EU but have so far refrained from entering EMU. On the other side, most internationally operating companies, at least in Sweden and Denmark, effect the majority of turnover in the euro area which might have led to a high degree of acceptance of the European currency in contracts, transactions and internal planning. 5

6 Table 2: Regional structure of foreign trade % in total exports and imports (2003) Exports to Imports from USA EU Rest USA EU Rest China South Korea Taiwan Hong Kong Singapore India Russia Mexico Brazil Source: IMF + China: Total foreign exchange reserves: USD 617bn 3 Exchange rate regime: USD peg According to table 2 China conducts approximately 15 % of its foreign trade with the EU. For this reason it makes some sense to convert part of the reserves into euro if this has not been done already. The euro should also have a prominent place in a currency basket which could replace the USD as the anchor currency in future. As the share of exports to the EU in total exports is not much different from that of imports and raw material exports play only a very minor role if at all, open foreign exchange positions cannot be identified. Taiwan: Total foreign exchange reserves: USD 241bn Exchange rate regime: Controlled floating Taiwan s foreign trade structure is similar to that of China. As Taiwan has no formal exchange rate peg to the USD it is likely that the euro already plays a bigger role in foreign exchange policy and as a reserve currency. +South Korea Total foreign exchange reserves: USD 200bn Exchange rate regime: Controlled floating Basically, the same conditions prevail as in the case of Taiwan. The central bank announced recently that no plans are on the table to substitute already existing USD holdings with assets denominated in 6

7 other currencies. However, the bank does intend to purchase other foreign exchange in the course of future interventions 4. We regard this as an indication that the central bank is inclined to change the reserve structure in favor of euro and yen-based assets. +India Total foreign exchange reserves: USD 126bn Exchange rate regime: Officially controlled floating, limited exchange rate flexibility with the USD as anchor currency A relatively large trade share with Europe suggests that the euro is likely to gain in importance as a reserve currency. + Hongkong Total foreign exchange reserves: USD 124bn Exchange rate regime: USD peg Hongkong s foreign trade figures are blurred by re-exports from China. However, Europe plays a significant role as a trading partner. Being formally part of China, the authorities will sooner or later find it attractive to unify exchange rate systems. This will probably boost the euro s role as a reserve currency. +Russia Total foreign exchange reserves: USD 121bn Exchange rate regime: Controlled floating, currency basket used as yardstick in foreign exchange policy Europe plays a prominent role in Russian foreign trade. Moreover, there might exist an open foreign exchange position in the current account, as raw material deliveries (oil and gas) dominate exports and are invoiced predominantly in USD. On the import side the euro is likely to account for a greater share. Russia recently altered its exchange rate regime, with a currency basket replacing the USD as a yardstick stepwise 5. There are further signs that the central bank has already shifted part of reserves into the euro currency area. This will probably gain additional momentum in future. Singapore Total foreign exchange reserves: USD 110bn Exchange rate regime: Controlled floating Same as Taiwan. Mexico Total foreign exchange reserves: USD 64bn Exchange rate regime: Floating 3 Data on international reserves are taken from the IMF s IFS or national sources 4 Reported for instance in: Neue Zürcher Zeitung from 2/24/ Suomen Pankki Finlands Bank: BOFIT weekly 12, 3/24/2005 7

8 The US dominates Mexico s foreign trade. An open foreign exchange position could exist, as Europe s share in imports exceeds that on the export side, but this might not suffice to alter the investment strategies of the central bank. +Brazil Total foreign exchange reserves: USD 52bn Controlled floating Europe has a relatively high share in Brazilian foreign trade, pointing to an important role of the euro in reserve allocation. Will greater currency diversification in officially held reserves move exchange rates? With the emergence of the euro a diversification in official reserve holdings is likely. But it is another question whether such transactions could become one of the dominant forces behind the exchange rate development of the euro against the USD. At least in the short term markets will tend to react sensitively to statements by central banks in command of high international reserve holdings. For instance, the above-mentioned announcement by the Bank of Korea immediately sparked an appreciation of the European common currency against the USD. However, for a more fundamental analysis the following aspects deserve attention: In general central banks follow prudent and conservative investment strategies in reserve allocations. Their aim is to avoid losses from speculation which would be difficult to explain to the government, external auditors and the political audience. For this reason marked shifts in investment strategies tend to be the exception rather than the rule. Among industrial countries official holdings are heavily concentrated on Japan (foreign exchange reserves currently exceeding USD 830bn). Will the Bank of Japan also alter its investment strategy in favor of more euro-denominated assets or has it already done so? It will certainly not work against the trend of a strong euro against the USD on foreign exchange markets as such a development bolsters the competitiveness of Japanese firms against European competitors. Moreover, it shifts the burden of adjusting the massive imbalance of the US current account deficit more to the euro area. Of course, the yen could itself come under upward pressure should central banks prefer yen-denominated assets in order to diversify their reserve holdings. Although G7 central banks are important players on foreign exchange markets, they have always insisted that it is not possible to change the fundamental trend of an exchange rate by means of intervention. This might also apply to an altered investment strategy by emerging market central banks. The reason for this limited role is that private capital flows are stronger and therefore more likely to determine a currency s medium-term exchange rate. Statistics on international finance holdings bolster this argument: Official reserve assets of emerging market and developing countries stood at USD 8

9 2250bn at end-october According to the BIS statistics, cross-border liabilities to nonbanks of international banks reached USD 4442bn alone by mid And international security and equity holdings, which also mirror asset allocations are not even included. We derive two conclusions from our analysis: 1. Given the economic size of the euro area it is likely that the euro will play a greater role as an international currency in future. This trend will be driven predominantly by private market participants. In reflection of foreign trade flows central banks are also likely to invest a rising part of their reserves into euro-denominated liquid assets. Moreover, with reserve accumulation in some key countries reaching record volumes, the currency structure is determined less by the foreign exchange rate policy and/or bilateral trade flows and more by asset allocations with an implicit strategy to diversify reserve holdings. The international role of the euro, but also that of the yen, should profit from this behavior. As most central banks probably maintain part of their reserves in euro and given their generally prudent and conservative investment behavior sudden shifts in the currency structure of reserves are unlikely. 2. As in the past, decisions of private market participants will be the main driving force behind exchange rate developments. But this does not rule out that the ambition to diversify official reserve holdings will sustain the euro s exchange rate against the USD in the long term. Diversification of reserves does not necessarily mean conversions of already existing USD assets in the hands of central banks, but could also reflect newly acquired holdings in the course of interventions. 6 BIS, page A 9 9