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Volume 1 - Issue 24
February 28, 2005
The BoK's Announcement
& the US$
By Louis-Vincent Gave
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This week we will turn once again to a group headquartered in Hong Kong called GaveKal Research Limited. Louis Vincent Gave's GaveKal Ad Hoc Comments for Wednesday, February 23, 2005 looks at the possible implications of the recent announcement by the Bank of Korea to diversify their holding away from the US dollar.
He uses the term "sterilize" a lot, and it is important to understand this process. Countries sterilize their currency to maintain fixed exchange rates and Investopedia.com defines "sterilize" as "using offsetting open market operations to prevent an act of exchange market intervention from changing the monetary base." If the country does not sterilize the incoming currency, it will "infect" the money supply and could cause inflation. Basically it does this by buying or selling bonds in the local currency.
Gave goes on to discuss the explosion in foreign central banks US dollar reserves and suggests that the dollar will strengthen in the future rather than fall. This idea is at odds with my longer term forecast of a weaker dollar and that is why it made this week's Outside the Box. (Of course, I did note in my annual forecast that I thought the dollar could strengthen in the short term.)
- John Mauldin
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The BoK's Announcement & the US$
February 23rd, 2005
by Louis-Vincent Gave |
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Yesterday's announcement by the Bank of Korea that it was looking to
diversify its foreign exchange reserves from US$ into other currencies has
renewed the selling pressures on the US$. In 24 hours, the US$ has lost -
1.4% against the Euro, -0.7% against the Yen and Sterling, the NZ$ is
making all time highs etc...
So what should we make of the BoK's announcement? Will this decision be a
heavy burden for the US$? Will it be the proverbial straw that breaks the
US$'s back? Or are the markets over-reacting? In the following few pages,
we aim to answer some of the questions posed by the BoK's announcement, and
the consequent market reaction.
1- How Big of An Impact Would BoK Selling Have?
As anyone involved in the financial markets knows, prices are made at the
margin. Consequently, the news that the Bank of Korea will become a seller
of US$, instead of a natural buyer, can hardly be perceived as good news
for the US$. But having said this, the question then becomes how much of a
seller of US$ the BoK will become. And on that point, the announcement was
very vague.
Looking at the growth in reserves of the Bank of Korea, last year saw
record inflows of over US$40bn, bringing the BoK's total reserves to
US$200bn.
Now undeniably, these are not small amounts; and backed by these reserves,
the BoK could be a major player in the foreign exchange markets. But having
said this, the amounts moved around by the BoK are still dwarfed by the
amounts of the BoJ [Japan], and the PBoC [China]. In the world of central
bank forex intervention, the BoK is still a second division player!
More importantly, looking at the above chart a question needs to be raised:
are investors betting on big sales of US$ from the BoK's not simply
projecting the recent past into the future? After all, the annual growth of
Korean reserves has not been a steady affair. Some years (1988, 1991, 1997,
1998) have seen a contraction in reserves, while others (1989, 1999, 2001)
have seen the growth in reserves fall abruptly. And when that happens, the
Bank of Korea does not go out and sell US$ in the open market. Quite the
contrary!
Over the past year, the BoK has been accumulating reserves at a record
pace. But is this pace likely to continue? As is visible from the chart,
the past year's growth seemed to be somewhat of an anomaly... and betting
on the BoK's ability to sell US$ in the market could be betting on a
continuation of the past year's anomaly.
2- Haven't Asian Central Banks Been Diversifying Anyway?
Last November we wrote a lengthy piece entitled "What Investors Should Know
About the US Current Account Deficit" in which, amongst many other things,
we attempted to uncover how reserves of central banks all over the world
(but especially in Asia) could have risen so much faster than their
underlying countries' current account surpluses? And the explanation we
found was simple enough: a massive game of double counting on reserves was
taking place. We wrote:
"Central banks like to keep enough US$ at hand to cover at the very least
three months worth of imports, and usually six. Once that is achieved,
then local government debt denominated in foreign currencies usually starts
to get repaid (i.e.: Thailand, Indonesia, Malaysia... 1998-2001). Once both
the reserves are secure, and foreign currency debts have been repaid, the
central bank will then usually look at the countries against which it runs
a current account deficit, and start accumulating reserves in that
currency.
To take an example: once the People's Bank of China is secure with its US$
holdings, it will most likely decide to start buying some Yen (to cover the
cost of its imports from Japan).
Usually, those reserves are deposited at the central bank of the surplus
country (Japan, in our example above) and appear as liabilities in the
balance sheet of that central bank (assets held at the BoJ for the account
of foreign central banks).
Which then implies that the country at the receiving end of these transfers
(i.e.: Japan) now has two kinds of reserves: - The "earned reserves", which are more or less equal to the sum of the
current account surpluses over the year. These reserves are, by their very
nature, very stable.
- The "unearned reserves", which are the sum of the net private and public
(central banks) capital flows. These reserves are, by their very nature far
more unstable.
And unfortunately, it seems that most of the growth in reserves over the
past couple of years has been of the latter, unstable kind. As highlighted
in the chart below, while historically the difference between Japan's
current account surplus and its annual growth in reserves has been a
negative US$140bn, in the past year, it has grown to a positive US$200bn!
The above facts lead us to the conclusion that a massive game of "passing
the hot potato" is currently taking place amongst the world's central
banks. And in this game, the "hot potato" is US$ reserves (or trying to
show that one doesn't have too much to an increasingly uneasy US
administration) and the main players are the US, China, Japan and Asia ex
Japan, ex China. The other players (Europe + OPEC) are simply on the
receiving end of the game.
And the direct result of this game of hot potato is massive double counting
of reserves.
Staying with the same example as above: if China changes some of its excess
US$ for JPY and places the Yen for deposit with the BoJ, then overall
Chinese reserves will not change. However, if the BoJ turns around and buys
back the US$ that the Chinese have sold (to prevent the Yen from rising),
then Japanese reserves will go up-by the amount invested by China in Japan.
Importantly, a lot of these reserves do not belong to Japan, but to
China...in the official statistics, these reserves will appear as Japanese
reserves, because Japan does not give a breakdown of its reserves. But
these reserves could melt away like snow in the sun, if, for some reason or
other (i.e.: a trade deficit, the purchase of weapons system, a really bad
harvest, etc...) the PBoC decided it no longer wants to hold Yen but needs
US$ (or Euros, AU$, etc...).
Worse yet, if the reserves are kept at the People's Bank of China, and
deposited with commercial banks in Japan, the BOJ may not even know that
this is taking place...
Summing up the above, we can conclude that when a country (i.e.: China)
runs a current account surplus, and wants to maintain a fixed exchange
rates, it must first decide whether it wants to sterilize its FX
intervention, or not. In turn, the US$ bought on the market (whether
sterilized or not) can be used to buy Yen (or AU$, KRW etc...). This then
pushes the BoJ to intervene in the FX markets and either sterilize, or not.
We therefore have four possibilities: - China sterilizes and Japan sterilizes (2002 and early 2003, see An
Important Change in China): this is very deflationary for the world and
very positive for US Treasuries.
- China sterilizes, Japan does not: this is most unlikely but would lead
to a rapid fall in the Yen and an out-performance of Japanese equity
markets.
- China does not sterilize, but Japan does (situation prevalent today):
the Yen rise and Japanese equities underperform.
- Nobody sterilizes and money supplies accelerate rapidly: asset prices go
through the roof (this is what happened in 2003).
In any event, we would like to reiterate that the current situation is
highly unstable. The impressive growth in reserves shows that there either
exists a massive short US$ position in the system, or that central banks
around the world, but especially in Asia, have been double counting their
reserves. When reserves start to shrink, central banks will first liquidate
their third party currencies (mostly Yen and possibly AU$). And this could
add volatility in the financial markets at the worst possible time."
So given the above, we can draw two possible conclusions:
Conclusion #1: The Bank of Korea has already been diversifying its reserves
(in Yen, Euros, AU$...) and this recent announcement is a typical central
bank announcement; i.e.: the BoK is just stating the obvious.
Conclusion #2: While every single central bank in Asia (PBoC, BoJ, MAS...)
has been busy diversifying away from the US$ (hence the double-counting of
reserves), the BoK is finally waking up to the game that everyone else has
been playing and is hoping to get in on the action. In other words, the
growth in reserves of the BoK is not really linked to Korean trade, but to
the fact that other Asian central banks have been buying Won...and the BoK
now wants to send this money elsewhere!
Our experience of central bankers in general, and of Asian central bankers
in particular, would lead us to chose the former over the latter. But in
this decision, we truly show our prejudices: after all, the solid rise in
the Korean Won last year (from 1200 to 1050) and so far this year (from
1050 to 1004) would seem to indicate that, unlike other Asian central
banks, the BoK has not been extremely deft at manipulating the value of its
currency lower; last year, the Won was the world's best performing major
currency.
3- A Different Trend in Reserves in 2005
The most interesting part of the BoK's announcement is that, on aggregate,
the growth in foreign central bank reserves has started to decelerate. This
means that we are moving from an environment of plentiful, and weak, US$ to
an environment where US$ aren't as plentiful (and weak) as they once were.
So anyone who has borrowed in US$ could be scrambling to meet its
obligations.
4- Conclusion
The recent announcement by the BoK has knocked the wind out of the sails of
the US$. But beyond that the announcement is a non-event which does not
alter an important reality: today, the growth rate of US$ deposited at the
Fed by central banks is decelerating rapidly. And this argues for a
stronger, not a weaker US$. The US$ might test its December lows, but we
doubt it will pass them.
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