2015 was the year of considerable FX drawdown as desperate EM central banks attempted to rescue themselves from reality.
As Barry Eichengreen noted,
"Intervening to support an exchange rate that’s fundamentally overvalued is a fool’s game and a no-win situation, akin to a sovereign attempting to sustain an unsustainable debt burden rather than yielding to inevitable restructuring."
Goldman holds on to some hope as EM central banks’ reserves appear to have stabilized on aggregate, at least for now.
In October (the latest month of comprehensive EM data from the IMF), declines in reserves ex gold in Saudi Arabia, Argentina, and to lesser extent Mexico and Russia, were offset by modest accumulation in a number of other emerging markets, led by India and—somewhat surprisingly—China. (The People’s Bank of China or PBOC unexpectedly reported an $11n increase in reserves in October, but factoring in other data suggests that FX outflow persisted that month at an estimated $26bn.)
But China’s FX reserves have on balance continued to decline, albeit at a slower pace. The latest reports from the PBOC (more recent than the IMF reporting for EMs discussed above) showed a large $87bn decline in FX reserves in November. However, more than half of this may be attributed to valuation effects given relative currency moves; indeed, our reading of a broader set of data from the State Administration for Foreign Exchange (SAFE) suggests that FX outflow amounted to about $39bn—up from October but still well below the monthly average of $144bn in August-September. This likely reflects the effect of a tightening in administrative control (including intensified crackdown on underground outflow), as well as some possible frontloading of corporate FX hedging activity and a slight moderation in bearish RMB sentiment.
US Treasury yields continue to show little impact from reserve selling. We maintain that a 1pp decline (roughly equivalent to US$125bn in net flows) of the share of Treasury stock held by the foreign official sector increases US 10-year yields by around 5bp, all else equal. However, macro drivers often dominate this effect. In the 16 months between the peak of EM FX reserves in June 2014 and October 2015, the roughly 2pp decline in the share of US Treasuries held by the foreign official sector has likely added around 10bp to the level of 10-year yields. This reduction in holdings, however, has not prevented 10-year Treasury yields from falling 30bp over the corresponding period.
Some observers attributed negative spreads between US interest swaps and underlying Treasury yields to central bank reserve selling, along with bank funding and balance sheet strain.
Quantitative tightening (QT) fears have faded for now. With EM reserve decumulation fading somewhat for now, fears that central bank reserve selling could offset the easing impact of central bank asset purchases—and ultimately tighten developed market financial conditions—seem to have subsided.
But this is what Goldman says to look for in 2016...
An environment that remains conducive for EM reserve drawdowns, or at least less friendly for reserve accumulation, amidst rising US interest rates, low commodity prices, and the ongoing bumpy deceleration in China’s growth.
- Oil exporters: Expectations of still-low oil prices through 2016 suggest that reserve assets of the oil economies with pegged currencies (e.g., SAR) should remain under pressure, albeit likely at a slower pace, as the required fiscal adjustment is starting to kick in. Further downside to oil prices would clearly mean faster reserve declines. Oil exporters with floating currencies (RUB, MXN, COP) will likely continue to allow their currencies to bear the burden of adjustment in case of any fresh terms of trade shocks.
- China: Pressures on reserves will likely continue to arise occasionally as growth decelerates, the PBOC responds with monetary easing, and currency uncertainty lingers, although pressures should not be as severe as during summer 2015. However, efforts to stabilize the currency, such as potential movement towards targeting a basket of currencies (which could be on the table, given the publication of the trade-weighted CNY index by the authorities), may reduce currency uncertainty and, in turn, outflow and reserve drawdown risk, barring implementation difficulties.
Some headwinds to US Treasuries from FX reserve selling, though this factor will remain secondary to macro drivers.
A potential resurgence in QT fears should reserve selling pick-up again, especially in China.
* * *So more "Fool's games" and more unwind risks for massive carry trades.