For all the talk of quantitative tightening, it turns out global central banks actually accumulated reserves in the second quarter.
The specter of “QT” haunts markets on a near daily basis and because the post-crisis expansion of developed market central bank balance sheets has no real historical analog, it’s by definition impossible to know what the market impact will be as the Fed, the ECB and the BoJ attempt to normalize their holdings.
Critics charge that fears of central bank balance sheet rundown are overblown. “Correlation doesn’t equal causation”, skeptics will say, as it relates to charts that plot CB balance sheet holdings with the inexorable ascent of benchmark equity indices and the steady grind tighter in credit spreads.
Those critics are being deliberately obtuse. The stated purpose of ultra accommodative monetary policy is to engineer global reflation via the fabled wealth effect, so far from being a “conspiracy theory”, the notion that ZIRP, NIRP and QE inflate the value of financial assets is actually a stated policy aim.
Of course when you talk about “QT”, you can’t just confine the discussion to developed market CB balance sheets. You also have to take into account EM FX reserves and, in the same vein, accumulation of reserve assets by oil exporters who have recently enjoyed higher prices for their cash crop (if you will).
That brings me neatly to a new note from BofAML. “At first sight, the recent release of Q2 foreign exchange reserves data by the IMF indicates a small decline in global FX holdings from $11.6trn in Q1 to $11.5trn in Q2”, the bank writes, in a note dated October 8, referencing the following chart.
But that might be misleading. “Contrary to what the outright headline number would suggest, we find that central banks were probably net buyers of reserve assets through Q2”, the bank continues, before explaining as follows:
Though the value of reserves declined, an even larger drop would have been justified given the USD appreciation and the cheapening in most fixed income assets. We estimate an overshoot of around $115bn relative to what VAs would imply. In other words, our calculations suggest CBs bought a net $115bn worth of reserve assets.
What accounts for the accumulation of $115 billion in reserve assets during a time when EM FX came under enormous pressure?
Well, for one thing, policymakers in developing economies have leaned on a hodgepodge of levers and tools to mitigate FX pressure, which perhaps helped to limit outright intervention via reserve drawdowns.
In the case of China, BofAML notes that reserves remained largely steady despite yuan weakness. “Robust portfolio inflows, macroprudential measures and moral suasion may have limited the need for intervention [and] any FX intervention could have been restricted to the use of FX forwards”, the bank says, adding that “other EM central banks that saw their currency come under pressure (eg India, Hong Kong, Turkey…) could have had recourse to a mixture of instruments to avoid a large drop in reserves.”
Additionally (and as alluded to above), BofAML postulates that reserve accumulation by oil exporters may have offset any flows from FX intervention.
As an aside, you should note that this dynamic is partially driven by the fairly unusual simultaneous rally in the dollar and crude.
The bank goes on to flag evidence that the de-dollarization theme is gathering momentum. “All else equal, the share of USD holdings should have increased from 62.5% to 63.5% based on the USD appreciation recorded in Q2”, BofAML writes, stating the obvious. In fact, though, the share fell to 62.25%.
The read-through there is clear: Central banks that increased their reserves either bought non-USD assets or else everyone else diversified as the dollar rallied.
So which currencies benefited from the bias towards de-dollarization? If you said the Chinese yuan, you win a fortune cookie.
According to BofAML’s analysis, the share of RMB holdings surged by 0.44%, representing the biggest QoQ jump in history. And that’s not even the most shocking part.
“Although astonishing in itself, this percentage increase may still be significantly underestimating the RMB buying in Q2”, the bank continues, adding that if you account for CNH depreciation, “the increase in the RMB share would imply that CBs bought the equivalent of $55bn in RMB assets over Q2, compared to less than $17bn in Q1.”
Needless to say, that suggests that flows might well have mitigated the need for China to intervene in FX markets as the yuan dove.
BofAML goes on to remind you that a key part of their medium-term bearish outlook for the greenback is an assumed push towards de-dollarization, but they do note that “the move is likely to be glacial and will, amongst other things, depend on the China’s integration into global capital markets.”
Whatever the case, all of the above is highly interesting and highly relevant in the current environment, characterized as it is by an administration in the U.S. that’s pretty keen on using the greenback as a tool of economic warfare and deploying that weapon indiscriminately against allies and enemies alike.