Euro vulnerable as Asian FX reserve accumulation slows

Wed Jul 10, 2013 10:38am EDT

* Asian central banks' FX reserve accumulation slowing

* Amount to be allocated to euros set to drop further

* Likely to hurt euro and lead to more weakness

By Anirban Nag

LONDON, July 10 (Reuters) - Euro weakness could accelerate in coming months because Asian central banks, amongst the biggest buyers of the currency in recent years, will have smaller foreign exchange reserves with which to diversify.

Growth-linked Australian and Canadian dollars could also weaken as the Asian central banks grapple with capital outflows caused by a shift in the Federal Reserve's ultra-loose policy.

Until April this year, many Asian central banks were mopping up capital inflows to keep domestic currencies competitive against trillions of cheap dollars printed by the Federal Reserve made their way to Asia and other emerging markets and bolstered their foreign exchange reserves.

More than half of those were kept as dollars, but a quarter were recycled and diversified into euros. A smaller proportion was allocated to the yen, sterling, the Aussie and Canadian dollars, all which have earned better returns than the U.S. dollar.

But the tide of inflows has stopped after the Fed signalled in late May that it was ready to slow its $85-billion-a-month asset-buying programme, perhaps as early as September.

As a result, U.S. Treasury yields have risen and dollar-funded carry trades, in which investors borrow in a low interest-bearing currency to buy riskier and higher-yielding assets or currencies, are being unwound.

So with capital flows reversing, many Asian central banks are now selling dollars from their reserves to check a sharp drop in the value of their currencies. As they draw down reserves, they will have fewer funds to allocate to euros.

"The more weak growth in reserves we see in Asia, the less supportive it will be for the euro," said Neil Mellor, currency strategist at Bank of New York Mellon.

Indeed, the latest data from some of the largest Asian central banks such as South Korea, Hong Kong, India and Indonesia with nearly $1 trillion between them, shows foreign exchange reserves already fell in June from a month earlier.

Accumulation by Taiwan's central bank, another big player with over $400 billion, has stagnated.

As for China, which has the world's biggest foreign exchange reserves at over $3 trillion, recent data is unavailable. But some analysts say with China allowing its yuan currency to appreciate in recent months, reserve accumulation due to market intervention may also have slowed.

EURO LOSING OUT

This slowing reserve accumulation may leave the euro without one of its biggest supporters. Asian central banks have been steady buyers of the euro, even at the height of the euro zone debt crisis last year when Greece was close to collapse.

For most of the past decade, the euro has accounted for more than a quarter of emerging market foreign exchange reserves, topping at 28 percent in 2009.

But recent data suggests its share could drop below 20 percent, a level last seen in 2001/02.

IMF data released on June 28 shows that of the $11.1 trillion of global foreign exchange reserves, the euro's share fell to 23.7 percent in the first quarter of this year from 24.2 percent in the previous quarter - the lowest percentage value since the second quarter of 2004.

At the same time, the dollar's share rose to 62.2 percent from 61.2 percent.

"In addition to the cyclical justifications for our bullish dollar view, slower reserve accumulation and diversification should provide further support for the dollar in the coming years," said Evan Brown, currency strategist at Morgan Stanley.

It is all down to growth divergence between U.S. economy and others, notably the euro zone. The Fed is beginning to tighten while Europe remain in ultra-loose territory.

The euro has lost nearly 3 percent this year as investors price in more rate cuts by the European Central Bank.

"The recovery in demand for the euro by reserve managers has been anaemic; net purchases are running at a fourth of the historical pace even in the face of improved conditions in the eurozone debt markets," said Kiran Kowshik, strategist at BNP Paribas. "Diversification away from the dollar is slowing down."

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