China’s FX reserve accumulation and EURUSD4 June, 2012, 2:59. Posted by Zarathustra
Tags: Euro Crisis
For quite a while, most notably last year, one of the most puzzling things that the market has been discussing is that why Euro remains so strong? Why it is not yet at parity with the dollar?
While I am obviously very pessimistic about the future of the euro in an existentially sense, I am rather less sure about the exchange rate itself. After all, with the euro area deleveraging, euro-denominated debt will have to be repaid in euro, and that creates demand for the euro as debtors scramble for euro (at least that’s what could happen on paper).
Another popular theory, of course, is that China and probably other emerging market central banks have been buying in hope to diversify their FX assets away from US dollar denominated assets. This is by no means good for the eurozone economy, but this is probably what has been happening, until probably recently.
Financial Times is reporting that it appears that emerging market central banks have been selling Euro:
Central banks in emerging markets have been dumping euros to shore up their own currencies, contributing to the euro’s drastic slide in recent weeks, according to traders… Currency traders said central banks were among the biggest sellers of the euro – reversing their normal pattern of buying the single currency when it weakens to diversify their stockpiles of foreign exchange reserves.
This type of behaviour of emerging markets’ central banks are expected. In the period of global market stress when money outflow away from emerging markets happen, one would find that emerging market currencies go down as foreigners sell emerging currencies and assets. Central banks in these countries which are interested in defending their currencies (either because they have explicit peg with another currency like US dollar or because they have a soft peg) will have to sell foreign assets they own as FX reserve and buy their own currencies which are being sold by foreign investors. This action tightens domestic monetary condition, but this is another matter.
Notably, of course, that the Chinese central bank hold the largest FX reserve due to the long years of trade surplus and capital inflow. This era is already behind us, there has actually been very little dispute that with current account surplus shrinking (or even turning into deficits, as I just start to suspect) and capital inflow slowing, foreign exchange reserve accumulation will slow for China, and I would not be surprised if China will one day sell foreign exchange reserve assets in a big way into the future. But again, this is another matter.
Although euro-denominated assets are not the big part of Chinese FX reserve, the pace of FX reserve accumulation of China seems to show a weak link with Euro/dollar exchange rate in the past 5 years or so, as the chart below shows.