Tuesday, January 19, 2016 04.08 PM / Author: Otaviano Canuto. (Photo: Silvia Costanti/Valor/Folhapress)
After a exponential rise in foreign exchange reserves accumulation by emerging markets from 2000 onwards, the tide seems to have turned south since mid-2014. Changes in capital flows and commodity prices have been major factors behind the inflection, with the new direction expected to remain, given the context of the global economy going forward. Although it is too early to gauge whether the on-going relative unwinding of such reserves defenses will lead to vulnerability in specific emerging markets, the payoff from strengthening domestic policies has broadly increased.
One of the landmarks of the global economy in the new millennium has been the steep rise in foreign-exchange reserves held by central banks. From a total of US$ 1.8 trillion in 2000, global reserves reached a peak of US$2 trillion by mid-2014. They have declined since then (Figure 1).
The accumulation of foreign exchange reserves by emerging market economies has been a major factor during both upward and downward phases of the tide. Although the growth of reserves in China and other non-advanced Asian economies accounted for more than half of the expansion of reserves during the new millennium, emerging economies of other regions also experienced substantial increases
(IMF, Assessing Reserve Adequacy, February 2011). After a brief slowdown during the global financial crisis, the pace of accumulation by emerging market economies partially recovered, until the decline started around mid-2014 – this time also taking place in China (Figure 2).
Figure 2: Changes in Foreign Exchange Reserves of Emerging Market Economies (percent of GDP).Source: IMF, World Economic Outlook, October 2015
The global decrease of foreign exchange reserves by central banks since the second half of 2014, is to some extent explained by exchange rate changes, namely the euro and yen depreciation vis-à-vis the dollar, given the proportion of reserve assets denominated in the former currencies (Figure 1). In addition, changing trends in capital flows to emerging market economies and the sustained fall of oil prices – see Canuto, O.,
“One of the landmarks of the global economy in the new millennium has been the steep rise in foreign exchange reserves held by central banks.”
Broadly speaking, capital flows to emerging market economies slowed down after mid-2014. The “taper tantrum” of 2013 and the corresponding U.S. Treasury-10 sudden yield rise – see Canuto, O., Emerging Markets and the Unwinding of Quantitative Easing, CFI, October 2013 – was followed by a gradual descent over the following year. Nonetheless, interest rate spreads started climbing again after mid-2014 for emerging market economies and other risky assets – like U.S. high yield corporate bonds. Sovereign spreads expanded considerably, particularly for commodity exporters and countries affected by rising geopolitical risks. While global liquidity conditions remained loose, the perception of a general growth deceleration in emerging market economies – see Canuto, O.,
Lost in Transition, Project Syndicate, December 2013 – and the strengthening U.S. economic recovery, altered investors’ relative asset demands. Although idiosyncratic, country-specific developments played a role, as the overall enthusiasm for emerging markets assets wound down.
Figure 3: Gross Capital Inflows to Emerging Markets (excluding China). Source: IMF, 2015 External Sector Report, July 2015
Changes in capital flows to China have been remarkable. The combination of a huge current account surplus and a private sector capital surplus from 2001 onwards, led Chinese authorities to stockpile dollar reserves from US$ 170 billion in 2000 to US$ 4 trillion in August 2014, in order to contain what would have otherwise been a major exchange rate appreciation. The real exchange rate nonetheless appreciated by around 40 per cent after 2007, while the current account surplus moved down from 11 per cent of GDP in 2000 to 2 per cent last year.
Moreover, private capital flows turned negative since mid-2014, partially as a result of unwinding interest carry trades, given expectations of no further exchange-rate appreciation and interest rate reductions. According to Gavyn Davies, Financial Times, September 21, 2015:“In the past 12 months, private sector capital outflows have proceeded at a generally orderly pace, but have still forced China to reduce its reserves by $400 billion in order to prevent a precipitous drop in the exchange rate. It was not until the PBOC announced an adjustment to its exchange rate mechanism on 11 August, triggering fears of future devaluation, that the capital outflow hit crisis proportions. During August, the reserves dropped by $94 billion on the official figures, and many analysts think that disguised intervention in futures and options markets increased the genuine figure for currency support to over $170 billion last month.”