Hey, China and partners: are your international reserves adequate?

From my post at The Long Room, Financial Times Alphaville

FX Reserves in China decreased by USD 94 b to USD 3,557 b in August, the highest   monthly fall on record, the biggest fall in percentage terms since May 2012. While falling commodity prices, several other emerging market and low income countries have experienced drains in their international reserves too.

Sensational headlines aside, what matters is assessing how adequate FX reserves are as a country insurance against external shocks.

Rules of thumb for measuring FX reserves levels adequacy have been in use for years. Best known among them are:

• the 3-month import minimum as a cushion against foreign trade collapse; 
• the short term one year residual debt, known as the Greenspan-Guidotti rule for mitigating the market access risk; 
• the combination of both above plus the projected current account deficit, intended to reflect the full potential 12-month financing need;
• the, also arbitrary, 20% of broad money (M2) as a proxy for protection against the risk of capital flight.

Some newer approaches include the cost of holding reserves into the picture, therefore changing the question from what is an adequate level to what is an optimal level for a country´s FX reserves. Unfortunately they are very dependent on stylized modeling assumptions and calibrations which jeopardize possibilities for their practical use.

The IMF developed a new methodology (2011, 2013) to assess reserves adequacy which suits the need of practioners very well. It built upon older measures by offering a metric which weights the different sources of FX reserve drains.

As if it were a risk weighted capital ratio for assessing a bank´s solvency, the IMF established a minimum, adequate level of precautionary FX reserves for a given country. Weights are suggested for Short term debt (STD), Portfolio Liabilities (OPL), Broad money (M2) and exports (X).

Since the exchange rate framework matters during an event of FX market pressure, weights are lower for countries under flexible exchange rate regimes.

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IMF international reserves adequacy metric

Minimum expected outflows during exchange market pressure events

Fixed ER:   30% of STD + 15% of OPL + 10% of M2 + 10% of X

Floating ER:   30% of STD + 10% of OPL + 5% of M2 + 5% of X

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The IMF suggests that the adequacy requirement is met as long a country’s reserves lie between 100-150% of the metric defined above

When applying the IMF benchmark to China, those now diminished current levels are still 32% above the estimated cushion to cope with exchange market pressure. Minimum adequate FX reserves would be USD 2,702 b.  

The same metric applied to a China-exposed emerging country like Chile results in a similar 30% comfort margin:  IMF-metric, USD 29.3b as compared to USD 38.1b of current international reserves.

Indeed, both China and Chile have access to IMF contingent credit facilities. They both also hold Sovereign Wealth Funds which are in part kept as precautionary reserves for macroeconomic stabilization purposes, so they could eventually provide extra liquidity should that be needed from outside their own central banks.

Here comes the Yuan

From my post at The Long Room, Financial Times Alphaville

Last week our Central Bank in Chile signed a bilateral swap arrangement for RMB 22 billion with the People’s Bank of China (PBOC). This was the 31^stamong similar agreements reached by the PBOC with other central banks - (total over RMB 3.1 trillion) - but it is the first in Latin America which has included a quota   for private qualified locals wanting to invest in RMB.

The PBOC policy of bilateral central bank swap arrangements would allow the building up of Renminbi deposits in foreign central banks. Those swap deposits, according to IMF guidelines, ‘are treated as reserve assets because the exchange provides the central bank with assets that can be used to meet the economy’s balance of payments financing needs and other related purposes’.

That is why countries suffering international reserves stress like Argentina have been active users PBOC facilities, favoring trade ties with China.

Indeed, neighboring Chile is in the financial behavior antipodes of Argentina in regard to FX adequacy and external solvency. Thus, the PBOC strategy has aimed far beyond relying on FX stressed trading partners. Its target is to become an international reserve currency.

So far, it is almost there. The use of the Renminbi in money market instruments in the Bank of International Settlements increased from US$0.9 million in the 3rd quarter of 2010 to 29.56 billion in the 2nd quarter of 2014. The Renminbi is already the seventh largest reserve currency. It ranks 9th in the amount outstanding of international debt securities (East Asia Forum, Feb. 2015).

Moreover, it is known that at least 23 central banks received qualified investor status, hold RMB assets - (and/or CNH, the “off shore RMB” that is) - as part of their international reserves:

The list comprises all geographies:

·                     Australia, Hong Kong, Indonesia, Japan, South Korea, Macau, Malaysia, Nepal, Pakistan, Singapore and Thailand

·                     Austria, Belarus, Norway, France and Lithuania

·                     Bolivia, Chile

·                     Ghana, Kenya, Nigeria, South Africa and Tanzania. 

Ultimately, the RMB should reach the SDR currency status during the IMF review due this year. This after the “freedom of use” criterion as it is comprised in the set of requirements for broadening the SDR basket currencies be met - (i.e. ‘widely used’ and ‘widely traded’ clauses are satisfied).

The RMB admission as a fifth SDR currency would further consolidate current central banks diversification, strengthening demand for RMB with potentially big portfolio reallocations, some RMB appreciation and less USD-RMB correlation over time.

We should welcome the new reserve currency since transactions costs, international trade and capital movements would benefit development from the SDR status. It would be desirable that the PBOC take this new status opportunity to improve transparency on its COFER reporting to the IMF, the currency composition of their own international reserves, that is.

Settling for more

Central banks and FX risks

By Juan Foxley 

Posted at Financial Times Alphaville. A Spanish version published at América Economía.

Each day, an average of USD 5.3 trillion is traded in the FX markets. That is about 11 times equivalent to what primary dealers trade in US Treasuries at a given day and more than half a year trading value of listed stocks in the NYSE.

 

Being the largest market in the world is enough a reason for caring about safe settlement. Also known as “Herstatt Risk”, settlement risk may reflect in the loss of principal if one party to a FX transaction would deliver the currency it owes, but would not receive the bought currency from its counterparty.

Financial market regulators and some central banks gathered around the BIS have acknowledged settlement risk as the most significant system risk to participants in the FX market, accordingly began to provide recommendations and guidelines to mitigate it, also pushing authorities to do more:

" FX settlement-related risks have been mitigated by the implementation of payment-versus-payment (PVP) arrangements and the increasing use of close-out netting and collateralization.However, substantial FX settlement-related risks remain due to rapid growth in the FX trading market.…it is crucial that banks and their supervisors continue efforts to reduce or manage the risks arising from FX settlement. In particular, the efforts should concentrate on increasing the scope of currencies, products and counterparts that are eligible for settlement through PVP arrangements." Basel Committee on Banking Supervision (2012)

The main PVP arrangement is CLS – (Continuous Linked Settlement) -which is organized as a consortium of 63 banks, regulated by the Federal Reserve Bank of NY. - CLS operates a global multi-currency cash settlement system through which settlement risk is mitigated, using a combination of payment versus payment (PvP) settlement over CLS central bank accounts. These local currency payments are executed through local real time gross settlement (RTGS) systems with finality. Daily funding obligations are multilaterally netted to materially reduce the required pay-in values, which provide enhanced liquidity efficiencies for participants.

So far, USD 2.3 trillion -(settled volume divided by two)- is executed using the CLS infrastructure. That is, 43 percent of total FX world trading.

Unfortunately, not many central banks are joining CLS. Most notable exception is the Reserve Bank of New Zealand which is a shareholder member of CLS. Also, a few other central banks appear using CLS as third parties by contracting members´services: Colombia, Denmark , Hungary, Israel, Singapore, South Africa are among them.

One natural candidate for joining CLS would be Banco de Mexico. The MXN is already one of the 17 eligible within the multi-currency settlement system and, its domestic legal arrangements are in place for proper FX trade execution.

Other central banks missing from CLS are those issuing currencies which are exhibiting relatively high and increasing international liquidity  but are not yet part of the now 17-group. For example, China´s PBC and the central banks of Russia, Turkey and Brazil, among others.They would need to be proactive, twofold: in doing their legal and technical homework as it is required to win currency eligibility and, using themselves the CLS as the FX settlement vehicle. That would signal a commitment to system risk minimization while at the same time, duly protecting their international reserves against principal losses from Herstatt risk exposure.

www.juanfoxley.com