New Economist

Are emerging Asia’s reserves really too high?

Aside from China, no, according to a new IMF working paper by Marta Ruiz-Arranz and Milan Zavadjil. This is in large part an attempt to insure against a repeat of the 1997 Asian currency crisis:

The paper has presented evidence that to a large extent explains Asia’s large reserve accumulation since the 1997–98 crisis through the precautionary motive. Current reserve holdings in most of Asia (excluding China) are not seen excessive when compared with levels predicted by a simple model of optimal reserves applied to specific country and regional characteristics. By mitigating the potentially large welfare costs of crises, reserves provide benefits in terms of insurance that more than compensates economies for the
opportunity cost of holding liquid assets.

Large currency reserves have the added benefit of lowering borrowing costs:

Furthermore, the benefits of reserves in terms of reduced spreads on privately held external debt, and thus borrowing costs, further justifies most of the observed growth in reserves. The paper finds that a majority of economies in Asia continue to benefit from reduced spreads, as evidenced by the high estimated threshold levels beyond which no further gains are realized.

Nonethless, the authors consider that current reserves "are close to or have recently reached optimal
reserves levels", and "a slowdown in the pace of accumulation in Asia is now desirable."

China, meanwhile, remains an anomaly. These models "cannot fully explain the large stock of reserves in China" - a subject to be explored in future research.

What drives the growth in FX activity?

Earlier this year the Bank for International Settlements published their Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. The survey reported a massive jump in daily turnover:

Turnover in traditional foreign exchange instruments increased by an unprecedented 71% to $3.2 trillion.

What has been driving this upsurge? The latest BIS Quarterly Review includes a 10 page article which offers an explanation: What drives the growth in FX activity? Interpreting the 2007 triennial survey The three main factors identified by BIS authors Gabriele Galati and Alexandra Heath appear to be hedge funds, portfolio diversification of pension funds, and higher turnover of emerging market currencies:

Two specific findings stand out. First, the growth in transactions between banks and other financial institutions was particularly strong, consistent with the increasing importance of hedge funds, as well as portfolio diversification by institutional investors with a longer-term horizon, such as pension funds. Second, there has been a marked increase in turnover involving emerging market currencies.

The first two are not much of a surprise. The third can be seen as a by-product of the very healthy economic and trade performance of many emerging economies in recent years. In the past many emerging currencies had remarkably low fx turnover for the size of their economies; less so now.

Of babies and currencies

It's a connection I confess I never made when working in the City, but a recent MAS Staff Paper by Andrew K. Rose and Saktiandi Supaat, Fertility and the real exchange rate, claims that countries with falling fertility rates are likely to experience a depreciation in their currency:

We use a quinquennial data set covering 87 countries between 1975 and 2005 to investigate the relationship between fertility and the real effective exchange rate. Theoretically a country experiencing a decline in its fertility rate can be expected to have higher savings, lower investment, a current account surplus, and accordingly a real depreciation. We test and confirm this hypothesis, controlling for a host of potential determinants such as PPP deviations and the Balassa-Samuelson effect. We find a statistically significant and robust link between fertility and the exchange rate.  Our point-estimate is that a decline in the fertility rate of one child per woman is associated with a depreciation of approximately .15% in the real effective exchange rate.

So that's bearish for the yen, bullish for Africa?

India's strong rupee

India's strong rupee is an enviable problem to have, according to the Economist Intelligence Unit:

In some ways, the present strength of the currency, which is now hovering just above the symbolic Rs40:US$1 mark, is an enviable problem. It suggests that the country's attractiveness to foreign investors is increasing and signals optimism about the Indian economy more generally.

...the rupee's appreciation has benefited the economy by making imports cheaper. This is no small benefit--containing inflation has been high on the policy agenda during the past year, as the annual inflation rate (as measured by the point-to-point change in wholesale prices) rose to 6.1% in January 2007, compared with 4.2% a year ago. The inflation rate has subsequently moderated. This may offer the RBI some comfort in its battle against inflation, but the bank's new, stricter inflation target (4.5-5% in 2007/08, down from 5-5.5% in 2006/07) suggests that there will be one more increase in interest rates by the end of 2007.

Why is the currency so strong?

The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange inflows, especially US dollars. The surge of capital and other inflows into India has taken a variety of forms, ranging from foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slacken.

But it's not all good news:

Three myths about yuan revaluation

The latest Economist cover story and leader, America's fear of China, explains why bashing China over trade is not a good idea. But the more interesting piece is inside: Lost in translation. It argues that "If China sharply revalued the yuan, as American politicians are demanding, it could actually hurt the United States and help China." It's a long piece that is worth reading. Below I excerpt the section which claims that the standard arguments for a revaluation are based partly on a series of myths (emphasis added).

The first myth is that there is overwhelming evidence that the yuan is grossly undervalued. China's large bilateral trade surplus with America proves nothing. It largely reflects Asia's changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America's bilateral deficit with China shrinks by more than half. Even so, China's overall current-account surplus is also huge. The surge in its foreign-exchange reserves, to over $1.2 trillion, also suggests that the yuan is undervalued: without those massive purchases of dollars, the currency would have risen.

However, not all economists agree that the yuan needs to be sharply revalued. At one extreme is Morris Goldstein, of the Peterson Institute for International Economics, who argues that the yuan is undervalued by 40% or more against the dollar and should immediately be revalued by 10-15%. In the other corner many highly respected economists, including Robert Mundell, an economics Nobel prize-winner, and Ronald McKinnon, of Stanford University, strongly argue against a big appreciation of the yuan.

Economists find it devilishly hard to define the “correct value” for a currency. On purchasing-power parity (PPP), the yuan is clearly undervalued against the dollar. Perhaps by as much as 50%. But PPP is not useful for determining the optimal exchange rate between two countries of such different levels of income. It is natural for average prices to be lower in poorer countries because wages are lower. As countries get richer and their productivity rises, their real exchange rates appreciate. And although the depreciation in the yuan's real trade-weighted value since 2002 looks perverse, this follows a real appreciation of 50% between 1994 and 2001 (see chart 1).

A study by two IMF economists, Steven Dunaway and Xiangming Li, found that estimates for the undervaluation of the yuan ranged from zero to nearly 50%, depending on which method was used. Another recent study, by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii, concluded that using conventional statistical methods it is hard to prove that the yuan is much undervalued. Such uncertainty may partly explain why America's Treasury Department has so far ducked labelling China as a currency manipulator in its twice-yearly report to Congress. Another reason is that it is loth to give ammunition to the protectionist lobby.

Myth number two is that the sharp increase in China's trade surplus is due to an explosion in cheap exports. Until 2004 China's surplus was relatively modest, but it soared over the next two years (see chart 2). Jonathan Anderson, chief Asia economist at UBS, points out that export growth actually slowed between 2004 and 2006 (see chart 3). The main reason for the bigger trade surplus was a sharp slowdown in the annual real growth rate in imports, from more than 30% in early 2004 to less than 15% last year.

The entire increase in China's trade surplus since 2004 has come from trade in heavy industrial materials and equipment. China used to import increasing amounts of steel, aluminium, chemicals and machinery, but import growth collapsed after 2004 when the government started to tighten policy, causing a sharp slowdown in construction, one of the biggest importers of machinery and materials. At the same time China continued to invest heavily in metals and equipment, creating substantial excess capacity, so import growth remained relatively weak last year. Mr Anderson argues that imports should recover as overcapacity is used up.

The third fallacy is that imports from China destroy jobs and harm the American economy. It is hard to see how China can be blamed for job losses when America's unemployment rate (4.5%) is close to its lowest for decades. Trade with China may affect the composition of jobs in America, but it has little impact on total employment. It is true that some workers are harmed by trade with China, just as there are some losers from all international trade. But the American economy overall is better off, so in theory there is ample room to compensate any losers.

Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher. Commentators often refer to the “cheap” yuan as being an unfair subsidy for Chinese exporters. But it is a moot question who exactly is subsidising whom. Not only do cheap imports subsidise American consumers, but China's large purchases of Treasury bonds also hold down American interest rates, thereby subsidising home buyers. Suppose that overnight the yuan rose by 30%, what would happen? American interest rates would rise as China needed to buy fewer Treasury securities and prices at Wal-Mart would increase. If consumer spending and imports then collapsed, this would certainly reduce America's trade deficit, but in a much more painful way than most Americans have in mind.

UPDATE: Greg Mankiw links to and posts an excerpt from a 22 May Wall Street Journal article on the yuan by Matthew J. Slaughter

The rise of the euro

Conclusion: the euro will for the foreseeable future be by far the most important alternative to the dollar.

So writes Deutsche Bank economist Werner Becker in a new paper, Euro riding high as an international reserve currency (PDF). The euro's share of global foreign exchange reserves rose from 18% at the start of 1999 to around 25% by the end of 2003. Becker cites four factors why DB expect the euro share of global foreign exchange reserves to rise to 30-40% by 2010.

The vulnerability of the US dollar given the huge current account imbalances, the changes in exchange rate regime (e.g. changeover from a dollar peg to a basket of currencies with the euro as a core element as in the case of China), the central banks’ growing investment requirements and the increasing focus on returns.

But after 2010 the outlook is more murky. We could see a dollar renaissance. As for the yuan, don't hold your breath: while it has the potential to become an international currency, this will not be "until well after 2010." 

Curtains for the greenback?

The mighty greenback is slowly but surely losing its pre-eminence as the world's reserve currency. Consider the evidence:

1. The US dollar has fallen by more than 10 per cent against the euro and 14 per cent against the pound this year.

2. Asian central banks have been steadily diversifying their holdings away from USD-denominated assets into the euro, yen and pound.

3. Key petrodollar economies such as Iran, the UAE, Indonesia and Venezuela have said  they are looking to shift their reserves into euros or to price oil sales in the currency.

4. Today's Financial Times reports that Euro notes have overtaken the dollar:

The US dollar bill’s standing as the world’s favourite form of cash is being usurped by the five-year-old euro. The value of euro notes in circulation is this month likely to exceed the value of circulating dollar notes, according to calculations by the Financial Times. Converted at Wednesday’s exchange rates, the euro took the lead in October.

The figures highlight the remarkable growth in euro notes since their launch on January 1 2002, three years after the start of Europe’s monetary union, which in January welcomes its 13th member – Slovenia, the former Yugoslav republic.

“After the launch, we expected growth to stabilise – but it has continued over five years,” Antti Heinonen, head of the European Central Bank’s bank notes directorate, told the Financial Times.

Although the ECB does not deliberately promote the international use of the euro, it has become popular in official foreign exchange reserves – even if it is far from challenging the dollar’s lead as the most popular reserve currency.

Individually, these might be dismissed. Together, they point to a gradual erosion of the greenback's long standing dominance of global currency markets and central bank reserves.

I don't see this gradual diversification as a problem for markets - though there will be the odd exchange rate and asset class dislocation as large holdings shift. Nor does it augur the greenback's imminent collapse; more like a gradual weakening.

In time I expect it will be the yuan - rather than the euro - which comes to rival the dollar as the world's most traded currency (though clearly we are still a long way from that).

UPDATE: Felix Salmon of Economonitor offers five main reasons why there are more euros in circulation than greeenbacks. Meanwhile Dean Baker has this to say:

First, the dollar is not essential to world finance. People are happy to hold euros and other currencies, no one needs to hold dollars. Second, the euro passing the dollar is not some sort of cataclysmic event.

As long as people still have faith in the basic soundness of the dollar, they will be happy to hold it, even if it slides to number 2 by some measures. Of course, if investors become convinced that the currency is on a downward path, then it could lead to a serious run.

In short, the world does not need the dollar, but it is also not anxious to throw it in the toilet, or at least not yet.

Do currency futures tell us anything?

Quite a bit, actually - according to a New York Fed Staff Report by Joshua V. Rosenberg and Leah G. Traub. Their report, Price Discovery in the Foreign Currency Futures and Spot Market, compared price discovery in the foreign exchange futures and spot markets "during a period in which the spot market was less transparent but had higher volume than the futures market".

We develop a foreign exchange futures order flow measure that is a proxy for the order flow observed by Chicago Mercantile Exchange pit traders. We find that both foreign currency futures and spot order flow contain unique information relevant to exchange rate determination.

When we measure contributions to price discovery using the methods of Hasbrouck and of Gonzalo and Granger, we obtain results consistent with our order flow findings. Taken together, our evidence suggests that the amount of information contained in currency futures prices is much greater than one would expect based on relative market size.

Forex: London still dominates

The City does not dominate all financial markets, but forex is one that it does. UK's foreign exchange market accounts for almost one-third of global turnover, with its share steadily edging higher - helping to strengthen the City's position as a financial centre, according to a report by International Financial Services London:

Average daily turnover on the UK's foreign exchange market reached $1.1 trillion in April 2006, up 41% from the previous year... There was also a further $102bn traded in currency derivatives. Growth of trading in the UK outpaced the 38% growth in global foreign exchange volumes which totalled a record $2.7 trillion in April 2006 ($2.9 trillion including currency derivatives). Key factors in the increase of foreign exchange trading were its growing importance as an alternative investment and an increase in fund management and hedge fund assets.

London consolidates lead in global foreign exchange markets, writes David Prosser in The Independent:

"The rapid growth in the volume of foreign exchange turnover over the past two decades reflects the continuing growth of international trade and expansion in global finance and investment," said Mark Maslakovic, the senior economist at IFSL. "The UK, and London in particular, is by far the largest global market for foreign exchange trading, well ahead of the US and Japan."

This year, deals transacted in London will account for 32.4 per cent of all foreign exchange trading, according to IFSL's analysis. The UK's market share is almost twice as high as the next biggest player, the US, which has 18.2 per cent of all currency trading. Japan, with 7.6 per cent, and Singapore, with 5.7 per cent, are the next most important currency exchange markets but lag considerably behind Western competitors.

...Mr Maslakovic said the UK had developed into the ideal centre for currency trading since Margaret Thatcher's newly elected Conservative government abolished exchange controls in 1979. Until then, foreign investors were almost entirely prevented from buying sterling unless doing so would benefit Britain's balance of payments figures. UK residents, meanwhile, were not allowed to buy foreign currency for investment purposes, unless the purchases were funded with the sale of existing overseas assets.

...the liberalisation has subsequently enabled the UK to cash in on its geographical position as a bridge between the US, Europe and the Far East.

IFSL said the UK had a string of additional advantages as a centre for foreign exchange trading. They include: a large fund management sector; a large number of investment banks and brokers; easy access to global markets combined with a tradition of welcoming foreign firms; high-quality professional services; efficient telecoms infrastructure; and the use of the English language.

 

Yuan band to widen

China's central bank governor Zhou today repeated earlier comments that authorities would push for yuan convertibility: China says no timetable for yuan band widening

BEIJING, Sept 21 (Reuters) - China has no timetable for widening the yuan's daily trading band but will continue to take steps to gradually make its currency fully convertible, central bank chief Zhou Xiaochuan said on Thursday.

A recent acceleration in the yuan's strengthening has stoked speculation that Beijing could let it trade in a wider range  -- it is currently allowed to rise or fall by 0.3 percent each day against the dollar and by 3 percent against other major currencies.

Asked by reporters on the sidelines of a financial forum whether China had a timetable for widening the band, Zhou said: "There is no need (for that)."

Pressed on details of a potential band widening, Zhou replied: "It depends on whether the band is enough for the market." Zhou made similar comments last weekend at a meeting of Group of Seven nations in Singapore.

The yuan hit 7.9230 against the dollar on Thursday, its highest level since Beijing revalued it by 2.1 percent and untethered it from a peg to the dollar last July. It has now strengthened a further 2.36 percent since then. But in daily trade, it has normally risen or fallen by only a fraction of what the band would allow.

Zhou also said China would gradually push to allow the yuan to be freely convertible and step up efforts to improve the openness of its financial sector. While the yuan is convertible on the current account, which covers trade, China still restricts most capital account deals and analysts say full convertibility could be years away.

"We will continue to redouble our efforts to develop our financial markets, to widen the openness of our markets gradually and in an orderly way, and to steadily push for free convertibility of the renminbi," he said, referring to the alternate name of the currency.