Analysis: Final straw for decade-long FX reserve accumulation

LONDON Wed Jul 25, 2012 1:51am EDT

LONDON (Reuters) - 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 U.S. 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.

"This could be a watershed after the decade of dramatic reserve accumulation."

CHINA HALT

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 U.S. dollar, euro, British pound and Japanese yen currently command roughly 62 percent, 25 percent, and 4 percent each, respectively, of total reserves.

Shorter term, even a slowdown or halt in the pace of reserve stockpiling could have exchange rate implications as marginal demand wanes for more euros, sterling and yen from central banks such as China, who build their reserves via dollar currency pegs and then converted those dollars to the other currencies to conform to something like the average portfolio split.

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 liberalization may well be the final step to ending the relentless increase in loss-making stockpiles altogether.

Beijing's anger over what it called Washington's "short sighted" budget rows that led to the ratings downgrade last year was very public. Many assumed then that it would step up diversification from dollars toward euros and others as a result.

It has been less vocal so far about the German rating threat or indeed the seemingly intractable euro zone crisis at large.

But while China is probably no less angry about the fate of its euro savings, its relative silence may simply be because it now has so few alternatives to absorb its vast pool of cash.

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.

Hedge fund manager Stephen Jen of SLJ Macro Partners reckons this "negative cost of carry" on additional reserve accumulation for China has recently been in excess of $100 billion a year. Zero to negative nominal western yields merely compound this.

HISTORICAL SWEEP

The policy-driven reserve accumulation since the Asia crises of the late 1990s that prompted a drive towards national self-insulation has in many ways been the financial story of the past decade.

With world reserves more than quadrupling in the decade to 2011 - China's increasing 15-fold - they illustrate the rise of the emerging economic giants but also explain widening global imbalances while helping to stoke the most destabilizing credit bubble of the past century by lowering western borrowing rates.

Underlining their role in the credit boom, studies show that before the 2008 Lehman bust reserve managers had reached beyond safety for yield by boosting commercial bank deposits over government Treasury bills and engaging in securities lending that, inadvertently or not, boosted their holdings of riskier, less liquid debt securities.

What's more, domestic criticism of how reserves were managed and what risks were taken with them - such as the outcry that forced Russia's central bank to dump all its U.S. federal agency debt - suggests any return to "riskier" debt is far off at least.

In the end, with so little room for maneuver and domestic economies trying to rebalance away from exports as the world enters a period of slower growth, the outsize reserve mountains of the past 10 years may well have seen their day.

(Reporting by Mike Dolan; Editing by Hugh Lawson)