September 01, 2013

Aussies, Loonies and other central banks´friends

  A spanish version published in América Economía
english versions also available at Financial Times Alphaville and SimplyNoRisk

"There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of wisdom than in discussing questions of currency and exchange".

The famous Churchill´s sentence, very much in place when it comes to guessing when one particular currency shall weaken or strengthen. What we do know better is that in minimizing the chance of capital losses from currency fluctuations, a well diversified portfolio continue to be the cheapest and foremost risk management tool. That, the old Markowitz corollary, is what central banks have gradually put in practice over recent years.

Non-reserve currencies are nowadays a much higher proportion of international reserves. This is especially the case of central banks in emerging and developing countries where recent turbulence has not obscured the main fact: the share of non-reserve currencies- (all but the four SDR components plus the Swiss Franc)- reached 8 percent of allocated reserves this year. As a proportion, this is about four times higher than in 2007

Leading the new currency friends are Australian aussies and Canadian loonies (about 1.6% each). Reflecting its importance, the IMF´s  COFER report recently began to publish them individually. Among central banks,it is also well known  that Norwegian, Swedish and Danish Kroner; Korean Won and off-shore Renminbis are following suit.

Higher currency diversification has been facilitated by the increased level of reserves itself.  They have raised well above adequacy level standards (i.e. months of imports, short term debt service, size over GDP). Therefore, a satiated liquidity tranche has unleashed higher degrees of freedom at the investment tranches. The case for holding net foreign exchange assets in US dollars-(and the other three composing the SDR basket, for  that matter)- weakened. More so when fundamentals remain fragile in most countries which issue anchor-currencies. No wonder, several central banks are known to hold CAD and AUD denominated assets (e.g. Brazil: 9.1 percent; Chile: 13 percent; among many others).

Interestingly, last 12 months performance of  those two popular non anchors disappoints. The AUD and CAD spot rates show 14 and 6 percent losses against the USD, respectively.

Are these AUD and CAD losses a reason to dismiss these new currency friends altogether? 
Of course, not.
The role of the newcomers is not to add capital gains but to cushion exchange rate volatility, hopefully bringing with them a dose of negative correlation to the returns on the currency portfolio. The Won and Euro appear to fulfill that role, gaining 3 and 6 percent, respectively.

Another way to evaluate performance and pursue asset allocation for investment tranches would focus on the local currency as the numeraire. This is becoming common practice among central banks that care for their status of independence and core capital preservation on their books. Even inflation adjusted domestic currency is utilized.

As an example, the figure below illustrates the case for Chile. When measured in local currency units, the AUD continued to be a drag but the CAD parity becomes Peso neutral, while Euro and Won holdings being a positive

Aussies and Loonies versus Euro and Won, against the Chilean Peso
(click to enlarge)

Would it be better to diversify away of AUD and CAD? 
May be. 
Empirically, nobody could be sure about observed variance-covariance patterns. Correlations may shift or even reverse over time. 
Conceptually however, the following asset allocation rule would be very much in order: a central bank from a commodity exporter country would be better hedged against currency risk when the value of its reserves would move opposite to commodity prices. Therefore, beyond liquidity considerations, Aussies - (among other so called commodity-currencies)- would not be best friends for central banks at commodity exporting countries. And good friends are needed to help you cope with pressures over your international reserves.