On Tuesday, I took an updated look at the liquidation of EM FX reserves.
When we talk about reserve drawdowns, we’re really talking about China and OPEC or, even further to the point, China and Saudi Arabia.
China is of course burning through its war chest in order to manage the RMB’s painfully long and drawn-out depreciation while Riyadh and other producers have turned to their reserves in the wake of the plunge in crude and quick death of the petrodollar in late 2014.
As noted, the liquidation of FX reserves means the selling of US and other core paper. This, effectively, is QE in reverse.
One question you might ask is this: with oil prices having stabilized following the OPEC/non-OPEC production cut deal, are we going to see producers building their reserves (i.e. recycling their petrodollars) again via the purchase of core paper?
Well, that (largely) remains to be seen, but what’s interesting to note is that to the extent holding core paper is a defense mechanism against FX vol, the UK’s populist shift may have killed sterling’s reserve status.
Via Deutsche Bank
Foreign investors have returned to the UK gilt market over the past quarter as valuations are attractive in dollar terms. Yet although this may have involved some recycling of petrodollars, we are skeptical that sterling will benefit from a broader reallocation of EM currency reserves managed by central banks. To the extent that reserves serve as backstops against currency stress, rather than as sovereign wealth, the pound’s diminishing role in international capital flows post-Brexit should permanently reduce its reserve status. Central banks stock currencies to which their own currencies are most susceptible via trade and capital flows.
In a model of China’s currency allocation we describe elsewhere, we estimate that the pound’s share has likely fallen from close to 10% into low single digits since early 2015 (chart 2), consistent with the PBoC transitioning from wealth to currency management. The pound may offer value but is increasingly irrelevant.
So two things to note here that each reflect points I’ve been keen on driving home: 1) political turmoil (i.e. the shift towards populism and nationalism) has very real economic consequences, and 2) increasingly, the financial universe is governed by the interplay between geopolitics and FX vol.