The IMF’s quarterly Cofer data, which tracks the size and currency allocation of the world’s FX reserves, revealed that – net of valuation effects – total holdings fell for the first time since the first quarter of 2009.
The decline was relatively modest – a fall of $7.3 billion compared with $66 billion in the first quarter of 2009. However, in both those periods EM reserve managers contributed to 75% of the decline, indicating a drawdown of stockpiles to protect their currencies against further weakness.
Indeed, the figures confirm the trend witnessed from more high-frequency data produced by individual EM central banks that authorities in developing countries were forced to intervene in the FX market after the Federal Reserve floated the idea in May that it might taper its bond purchases.
That saw global bond yields rise and triggered a sharp sell-off in EM currencies.
Kiran Kowshik, FX strategist at BNP Paribas, says as a result, reserve diversification from EM central banks, which has been a persistent source of pressure on the dollar in recent years as countries have sort to diversify their currency portfolios and reduce their reliance on the US currency, abated in the second quarter.
“At an aggregate level, FX reserve diversification appeared non-existent, with purchases of non-dollar currencies coming to a halt,” he says.
| Reserve growth contracts and diversification at an aggregate level stalls |
 |
Total FX reserves amounted to $11.1 trillion in the second quarter. The proportion held in dollars by those central banks that report the currency breakdown of their holdings to the IMF – known as allocated reserves – held steady at 62%, while the euro represented 24% of stockpiles, and the pound and yen each accounted for about 4%.
The biggest shift in holdings was in what the IMF describes as “other currencies”. Those are the currencies for which the IMF does not report individual breakdowns – everything except for the dollar, euro, yen, sterling, Swiss franc and the Australian and Canadian dollars.
As the chart below shows, the holdings in other currencies dropped by 30% in the first quarter.
| "Other currencies" in reserve managers' portfolios ($billion) |
 |
Steve Englander, head of currency strategy at Citi, says apart from some reserves that are held in the Norwegian krone and the Swedish krona, the 30% drop in other currencies probably reflects a drop in EM currencies.
Almost all the drop in reserves denominated in other currencies came from countries classified as developed by the IMF.
Englander notes that G10 countries, other than Japan and Switzerland, have relatively low levels of reserves and are not adventurous in managing them. Furthermore, he says nothing published by any G10 country suggests they were heavily invested outside of G10 currencies to any degree.
Thus the drop in reserves denominated in other currencies probably came from non-G10 reserve managers classified by the IMF as developed.
The drop in other-currencies reserves reported by the IMF can be caused by three different sources. First, actual selling of the currencies, second depreciation of the currencies and, third, capital losses on local currency bonds held in the reserve portfolio; EM rates rose sharply in the second quarter.
The weakest leading EM currencies in the second quarter were the Brazilian real, down 9.4% against the dollar, the Indian rupee, down 8.6%, and the South African rand, down 6.5%. Meanwhile, overall losses on un-hedged EM bonds in the second quarter were about 7% to 8%.
Thus, says Englander, there looks to have been a lot of EM selling by reserve managers in the second three-months of the year.
“On balance it seems hard to get even half of the drop to come out of valuation, so we probably saw a reserve manager dump of EM reserve assets in the second quarter,” he says.
Investors will therefore need to monitor trends to determine whether this was a one-off move triggered by the Fed’s pronouncements on tapering, or whether there is a more substantial change in stance by reserve managers towards EM currencies.
Two currencies that appear to have benefited from the shift away from EM currencies are the Australian and Canadian dollars.
Stripping out valuation effects, Citi estimates that reserve managers, principally in developed countries, added $16.8 billion and $13.5 billion worth of Canadian and Australian dollars respectively to their stockpiles in the second quarter. That represented a 15% rise in both currencies during the quarter.
| First half reserve manager buying of CAD and AUD ($billion) |
 |
Englander suspects that most of the buying occurred in the first half of the quarter when the Australian dollar and Canadian dollars were at the weak end of ranges that had been stable for months, with reserve managers seeing the weakness as a buying opportunity.
He says, however, given the subsequent move lower in both currencies, there might have been some “buyer regret” among reserve managers over their Australian and Canadian dollar purchases, even if, to some extent, they represented a rotation out of weakening EM currencies.
“It is possible that reserve managers unloaded Australian and Canadian dollars in the third quarter when both were under strong pressures,” says Englander. “But with first-half buying totalling almost $50 billion, we suspect that they were not able to exit to the degree they would have wished, given that the private sector was also selling.”
That would seem to leave the Australian and Canadian dollars vulnerable to further reserve manager selling on any renewed weakness in the two currencies.