For about three weeks, beginning on August 11, just about all anyone wanted to talk about were EM FX reserves.
The conversation starter was of course China’s “surprise” yuan devaluation which, contrary to the official narrative, did not in fact give more of a role to the market in determining the exchange rate. In fact, the PBoC’s hand became even heavier. As BNP so eloquently put it, “whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, [thus] the role of the market in determining the exchange rate has, if anything, been reduced in the short term.” A reduced role for the market meant an increased role for Beijing and that, in turn, meant liquidating FX reserves to control the spot.
Well about a week into the new FX regime, everyone began to take a look at just how much in US paper China was burning and suddenly, the world woke up to what we’d been saying for months, namely that not only was the pace of China’s UST liquidation set to increase going forward, but in fact Beijing had been a seller of USD assets for quite some time.
Subsequently, the market came to understand what we first began to discuss in our November 2014 classic, “How The Petrodollar Quietly Died, And Nobody Noticed [9]”: between slumping commodity prices, FX pain, and, as of August, the China deval, the “great accumulation [10]” (as Deutsche Bank would later call it) was over. EM had begun liquidating their UST warchests and ultimately, every analyst on the street as well as every mainstream financial media outlet would end up documenting exactly what we had been saying for the better part of a year: when EM liquidates its reserves, it’s QE in reverse and thus amounts to a drain on global liquidity as commodity producers cease to be net exporters of capital.
All of this figured heavily in the Fed’s decision to adopt the “clean relent” in September but because the market has a short memory, the global EM FX reserve liquidation story has been largely forgotten even as commodity prices remain in the doldrums and even as a laundry list of idiosyncratic factors are still weighing on the world’s most important emerging economies from Brasilia to Ankara to Beijing to Kuala Lumpur.
Bear in mind that just as QE floods the market with liquidity, the liquidation of EM FX reserves sucks liquidity out and thus should exert a tightening effect even as DM central banks (minus the Fed) struggle to meet market expectations for easing. There are obviously a number of mitigating factors here, but the point is that the conditions which prompted EM to liquidate their reserves have not changed and indeed, things could get materially worse depending on how things shape up in Brazil and Turkey and depending on the trajectory of the Chinese economy (SDR-induced inflows or no, there’s still a hard landing and capital is still flowing the wrong way).
Against this backdrop we present the following two graphics from Credit Suisse who looks at the relationship between FX reserves and, i) global equities, and ii) global growth. While the bank’s opinion is that “the problem is GEM growth not FX reserves,” and while they caution that correlation “does not establish causation,” the graphics speak for themselves.
Take a look at the divergence and draw your own conclusions about where we're headed:
[11]
