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.

Even Plain Vanilla Investment Funds can pose risks

IMF Survey

More transparency needed on international reserves holdings

My post at The Long Room, Financial Times Alphaville

Data on the composition of foreign exchange reserves by central banks is unfortunately getting less transparent.

As the recently released COFER statistics show, an increasing proportion of international reserves holdings are reported as unallocated - (i.e. central banks chose not to deliver information on individual currency composition but only aggregate figures).

Consequently, we can only know the currency composition for 52.6% of the world´s international reserves, down from 55.8% in 2012 and well below 78.4% in 2000.

Reported currency composition and total international reserves

WORLD		Q3 2012	Q3 2013	Q3 2014	Change 2012-14
Allocated		6019	6192	6185
Unallocated		4767	5249	5584
Total		10786	11441	11769	9,1%
% reported		55,8%	54,1%	52,6%	-3,2
EMERGING AND DEVELOPING COUNTRIES
Allocated		2765	2836	2772
Unallocated		4366	4834	5157
Total		7131	7670	7929	11,2%
% reported		38,8%	37,0%	35,0%	-3,8
ADVANCED COUNTRIES
Allocated		3253	3356	3413
Unallocated		401	414	427
Total		3654	3770	3840	5,1%
% reported		89,0%	89,0%	88,9%	-0,1

Source: IMF

Unallocated reserves are mostly of emerging and developing countries origin. Since reserves grew the most at these countries, any persuasion effort towards more transparency should focus on them.

It is worthwhile to recall that transparency on foreign exchange reserves information is essential for keeping a sound sovereign credit standard. In particular, currency diversification is an important piece for any financial risk assessment. Currency risk opacity would do nothing to help a country´s credit worthiness.

A more active of the IMF in persuading country members to improve transparency and follow best practices on this matter would be needed.

www.juanfoxley.cl

Currency diversification at central banks: moderate but sustained

  My post at The Long Room, Financial Times Alphaville

Higher currency diversification towards the Australian and Canadian Dollar (AUD, CAD): this continues to be the path central banks follow in allocating its official reserves. By the end of 2012 the IMF properly started to publish those two currencies individually, along with the residual ¨other¨ currencies item, all exhibiting moderate but sustained gains since then.

No disaggregated information on the Chinese Renminbi holdings is available but evidence from some individual central bank annual reports suggested the CNY- (the off-shore Yuan)- has become eligible, mainly for time deposits. Its future significance as a reserve asset will depend on China´s progress towards further FX market floating. So far, market turnover for the CNY has increased, ranked ninth but still behind the Mexican Peso in 2013, according to the the well-known BIS triennial survey.

As expected, currency diversification has come at USD and EURs expense, the latter further hurted by exchange rate depreciation. Conversely, USD appreciation vis a vis continuing success in shrinking the US federal deficit over GDP, would lessen, eventually reverse, USD substitution trends.

Currency shares of allocated international reserves

(As of end of June, each year)

	2009	2013	2014	*Netting out exchange rate gains/losses  2009-2014
USD	62,81	61,86	60,66	59.93
EUR	27,57	23,85	24,19	25.02
GBP	4,28	3,82	3,88	3.57
JPY	3,02	3,84	4,03	4.41
CHF	0,12	0,26	0,27	0.23
AUD+CAD	n.a.	3,48%	3,92%	3.83
Other	2,20	2,89	3,05	3.01
	100	100	100
CAD	n.a.	1.79	2.02	2.05
AUD	n.a.	1.69	1.90	1.78
AUD+CAD+Other	2.20	6.37	6.97	6.84

Source: IMF Currency Composition of Official Foreign Exchange Reserves (COFER, Sept. 2014)

*Author´s calculations, assumes no exchange rate change for ¨other ¨, with the USD as the numeraire.

www.juanfoxley.com

Gold and humility lessons from the central banks of Switzerland and... Venezuela

   My post at The Long Room, Financial Times Alphaville

A Spanish version available at America Economía

Huge losses from gold holdings among central banks are a reminder that international reserves must be properly diversified, otherwise not serving its capital preservation purpose which is supposed they are there for.

Today´s news from the Swiss National Bank (SNB) said it expected to report a USD 9.9 billion loss in 2013, a year when the precious metal price fell 28%. Financially, losses are equivalent to less than 2% of total international reserves however; a tangible consequence is the SNB will not be able to distribute dividends to the Swiss Confederation and regional cantons.

It could have been worse. A plan contained in a popular referendum that would require it to keep at least 20% of its assets in gold has not been passed yet. In fact, Swiss authorities are suggesting a no-vote on that. Gold holdings are at a lower, but still risky, 8.3% of the central bank reserves.

Indeed, there may be good reasons to have gold as a reserve asset: the lack of credit risk, long term store of value and safe heaven behavior are key features for central banks.  More so, after 2008. The question is of course, not ´if´ but ´how much´ to hold.

But in the ´how much´ issue, the consequences of overdoing it may be terrible. Venezuela may turn the Swiss case as a minor anecdote in this respect. Its later government decided the central bank to move away drastically from USD holding into gold, ending up with 68.9% of less liquid, loss making international reserves. Therefore, even if sound macroeconomic management were in place in Venezuela-(which of course, is not)- the sole lack of diversification of its international reserves would have cost Venezuela USD 4.9 billion last year, that is about 20% of its portfolio. 

Bottom line: Switzerland and Venezuela may have sidereal differences but its central banks are not free from the adverse effects of asset missallocation of its international reserves.  Indeed, a new lesson in humility to investment policy authorities worldwide.

Traditional portfolio optimisation may be evolving to allow for more dynamics in parameter estimation but the basic fact remains: a fairly high degree of asset diversification is both fundamental and sound as a guiding principle for risk management. Portfolio concentration is undesirable and even a naive [1/N] rule is a perfectly robust heuristic when, as it is usually the case, the assumed stability of asset returns and correlations in Markowitz-type models does not make sense.  

 www.juanfoxley.com