Don’t look now, but China’s FX reserves may become the market’s most important risk-on/ risk-off trigger.
Just as the world finally woke up - with the standard two or three year lag - to what we’ve been saying about an acute lack of liquidity in bond markets on the way to making corporate bond market liquidity the talk of the financial universe, so too has everyone suddenly realized why we began shouting about the death of the petrodollar last November. The drawdown of EM FX reserves - or, as Deutsche Bank calls it, the end of the “Great Accumulation” - means a withdrawal of liquidity from global markets and the cessation of the perpetual bid for US paper that had been sustained for years by the buildup of emerging markets’ war chests.
Now, between falling commodity prices and the global currency wars, the assets in those war chests are being sold, and that means the Fed faces a very, very difficult decision on whether to hike.
It also means that market participants will be watching EM FX reserves more closely than they have at any other time since the Asian Financial Crisis, and that, in turn means that data on reserves, and especially on China’s reserves, is set to become very important as a catalyst for risk-on/ risk-off behavior. On that note, we bring you the following commentary from Goldman out this morning.
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Following the RMB devaluation some weeks ago, markets have been erratic, fearful that the initial move was the beginning of a larger devaluation cycle that could disrupt global markets. We don’t believe this, in part because we think the RMB is close to our estimate of 'fair value', as we showed in a recent FX Views, so that the rationale for a bigger weakening does not look strong to us. That said, markets remain sceptical and are looking to August FX reserves, which will be published overnight (New York time) Sunday to Monday. Consensus (according to data collated by Bloomberg) expects total foreign exchange reserves to fall to $3,580bn from $3,651bn in July, a drop of -$71bn. We estimate valuation effects for the month around $21bn, driven mostly by the rise in EUR/$, which means that the underlying “flow” change in reserves would be -$92bn. Combining this with consensus for the August trade surplus ($49bn) and assuming that the current account surplus is lower due to service outflows, the underlying net capital outflows could be north of $100bn, which seems to us to be a reasonable approximation of market expectations. We think risks are skewed to the upside relative to this consensus estimate.
Given how worried markets have been about China, a better-than-expected reserves number holds the potential for risk assets to rally as devaluation fears abate. That said, the next data point on FX reserves will not be the definitive word on flows, since PBoC FX reserves in recent quarters have not been a good predictor of “true” flows as measured by the Balance of Payments (BoP). In particular, the mapping from PBoC reserves to BoP flows went off track from Q4 last year, with PBoC reserves first over-predicting reserve accumulation in Q4 and Q1, by $50bn and $100bn respectively, and then under-predicting in Q2 (by $100bn). In other words, some caution will still be advised in drawing conclusions on flows, where we see the BoP data as the ultimate arbiter. Our EM strategy team has discussed the broader EM context here.
An additional perspective can be gleaned by looking at official foreign exchange reserves in the rest of non-Japan Asia (NJA), where we also include information on forward books when that is available (Hong Kong, Philippines, Indonesia, Thailand, Malaysia, Korea, India and Singapore). Data for most countries are available through July, but the Bank of Thailand publishes weekly data for the bulk of August. We estimate FX-valuation-adjusted declines in reserves (including forward books) at -$9.2bn for Malaysia in July alone, at -$5.8bn for Thailand in July and August, at -$3.6bn for Indonesia and -$2.9bn for Hong Kong. These declines in official FX reserves are sizeable, and the example of THB suggests that depreciation pressures more generally may have risen materially. The look across the region therefore bolsters our view of potentially bigger outflows from China than is implied by consensus.