Foreign Currency Reserves Are Building: What It Means For Emerging Markets

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Includes: CYB, EEM, EWG, EWI, EWN, EWQ, EWU, FXF, GXC, OIL, SPY, UDN, UNG, USO, UUP
by: Long/Short Investments

Summary

Foreign currency reserve increased in February.

Countries may increase reserves for various reasons, but most commonly as a buffer against uncertainty in the global macro environment and to prevent (excess) appreciation of their currency.

An increase in reserves may be a bearish signal for emerging markets for factors listed below.

Central argument: Foreign currency reserves among several central banks worldwide rose in February.

This can be taken as a largely bearish factor for emerging markets (NYSEARCA:EEM), as it signals a combination of factors including: legislative uncertainty in the US (e.g., passage of pro-business reforms, trade), signals of higher interest rate in the US (i.e., higher interest expense and borrowing costs in emerging markets), uncertainty regarding the future ramifications of the UK (NYSEARCA:EWU) extricated from the EU, election outcomes in France (NYSEARCA:EWQ), Germany (NYSEARCA:EWG) and (possibly) Italy (NYSEARCA:EWI), central bank perceptions of overinflated asset prices, and certain countries wishing to protect their own interests and avoid appreciation (or excessive appreciation) of their currencies.

Overview

Foreign currency reserves are assets maintained by a central bank denominated in non-domestic currencies, used to back liabilities on their own currency and as an additional tool to influence monetary policy.

China (NYSEARCA:GXC) made headlines earlier this week by increasing its foreign reserves back above $3 trillion after seeing them progressively fall in its bid to stem capital outflows and support the valuation of the yuan. The People's Bank of China is unlikely to try to counter the dollar's (NYSEARCA:UUP)(NYSEARCA:UDN) appreciation against the yuan (NYSEARCA:CYB) by following the Federal Reserve's monetary tightening, as its FY2017 growth expectations has dwindled down to 6.5%. China's growth recently dipped down below 7% in year-on-year terms for the first time in 25 years.

China is in the process of reorienting its economy from a standard export-based model to a more developed-economy consumption-based model with the rise of an increasingly urban, middle-class population. Thus a stronger currency can help boost purchasing power and better incentivize consumption.

As the US remains the only central bank in the developed world working to tighten its monetary policy, the pressure on China's reserves - and therefore its currency - is likely to increase. Increasing yields in the US incentivize greater migration of capital flows offshore. The Chinese government has sought to curb outflow channels by limiting currency conversions, restricting domestic corporations from investing offshore, and trying to snuff out grey/black market banking activity.

When central banks increase their foreign reserves, the prices of these currencies will increase due to higher demand. This will tend to weaken their own currency, or at least prevent it from appreciating more than desired. Weaker domestic currencies are often preferred in order to support domestic exporters, as it effectively cheapens their goods on the global scale and thus engineers greater demand for them.

Switzerland, which explicitly conveys the desire for a weaker currency, increased its foreign reserves in the past month to fight against the strengthening of the franc (NYSE:FXF). Investors who anticipate higher volatility in the EU amid a busy election year (e.g., France, Germany, maybe Italy) and excess volatility in the British pound are placing more funds into the franc as a safe haven.

To illustrate the Swiss National Bank's intent to protect against excess appreciation in the franc, it now holds foreign reserves equal to CHF668 billion (USD$658 billion). This is around 97.5% of projected 2016 year-end Swiss GDP of $675 billion.

(Source: Bloomberg)

An ongoing tightening cycle in the US also encourages an increase in foreign reserves in emerging market nations. Many developing market countries issue dollar-denominated debt to enhance its legitimacy (particularly if the domestic currency is volatile) to attract foreign inflows. When rates increase this debt becomes more expensive, negatively impacting the budget, and decreasing sovereign credit quality.

In response, investors require greater return on their investments and results in capital outflows. Central banks can combat this through monetary policy measures, either by raising rates or increasing foreign reserves.

Raising rates is only preferred when growth and inflation are at their desired levels and policymakers are okay with a potential appreciation in its domestic currency.

Boosting foreign reserves can work to mitigate upward pressure on the currency and protect its export sector, which is often vital to growth in emerging markets. Moreover, it helps build up a "rainy day fund" to help better facilitate a potential policy response to economic shocks.

Where will emerging markets head?

Emerging market assets have appreciated in 2017, and should finish the year in the green. But I don't think it'll repeat the strong performance of 2016. Last year was great for emerging markets as a whole for the following reasons:

1. Weak economic data coming out of the US and continued underperformance in developed economies generally. This pushed market participants over to the higher yields that can be found in emerging markets.

2. Stemming from reason one and perhaps due to the upcoming election season, rates were put on hold, causing the Fed to raise just once at the end of the year instead of the planned four rate increases at the beginning of the year. Investors had anticipated higher emerging-market debt costs. When they remained low, this was a direct tailwind for emerging markets generally.

3. Commodity rebound of close to 30%, which helps emerging markets as a whole due to the export-focused nature of their economies.

Emerging markets in 2017 are likely to be hampered for a few reasons:

1. The Fed, if it raises in March, could set the stage for further increases in September and December. This increase in dollar-denominated yields on emerging market debt will create higher interest and borrowing costs, increase investor returns requirements, and work to push funds out of these markets in the direction of developed economies.

If the Trump Administration is able to push forward its corporate tax plan and get the ball rolling with respect to deregulatory initiatives, the Fed could have reason to continue the pace of rate hikes. Real growth could perhaps increase to around the 2.5% mark at the median with inflation likely to increase toward 3% (or higher if the Fed were to stay behind the curve).

This would be bullish for rates and future expectations of developed-economy growth generally. Accordingly, this would decrease the need for investors to hunt for yield in more volatile emerging and frontier markets.

2. Commodities have less price upside. Oil (NYSEARCA:OIL)(NYSEARCA:USO) and natural gas (NYSEARCA:UNG) have slight upside, but I'd expect smaller single-digit percent gains in these assets over the next couple years. The supply side of the equation is still stuffed, which limits near-term gains even if the demand is there.

3. In general, spreads have been bid down so heavily relative to a year ago, that obtaining yield has required taking on progressively greater risk. Or simply, risk/reward looks worse than it did a year ago. Asset prices became somewhat cheap after the early-2016 rout that left the S&P 500 (NYSEARCA:SPY) at just 1,840 a week into February.

Without any real hard evidence that economic growth has substantively picked up since, the S&P 500 has climbed 28.6% since - mostly on the basis of a continuation of loose monetary policies and expectations of future expansionary fiscal policy.

Conclusion

The recent buildup in foreign reserves likely signifies some combination of the following:

1. Uncertainty over what legislation will pass in the US (e.g., corporate tax reform, deregulation, offshore cash repatriation, infrastructure spending).

2. Unknowns with respect to the future US stance on trade, with the chance of an overly protectionist bent adversely impacting various markets, both emerging and developed.

3. Signaling of rising rates in the US and the consequent effects of such - e.g., capital outflows from emerging markets to the US markets, higher debt/borrowing costs, lesser demand for commodities (which are often priced in US dollars).

4. Political election outcomes in France, Germany, the Netherlands (NYSEARCA:EWN), and (maybe) Italy.

5. The future standing of the UK apart from the EU and how its trade deals will be impacted. (The UK is the world's fifth-largest economy and represents 3.8%-4.0% of all global economic activity assuming a world GDP of around $75 trillion.)

6. Central bank perceptions of negatively skewed risk/reward from inflated asset prices. Of particular note is how rising US rates could influence the continued desire for risk assets (e.g., stocks, real estate, emerging market assets) as yields in lower-risk assets start to normalize.

7. Certain countries not wanting their currency to appreciate (or appreciate too quickly), causing them to buy up foreign currencies to create market demand for them. In effect, this devalues their own currency in relative terms.

In the end, it boils down to countries attempting to protect their own interests and hedging risks with respect to any macroeconomic concerns they foresee brewing. Overall, rising foreign currency reserves could be perceived as a bearish event for emerging markets taken collectively.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Net long the US dollar; short German sovereign debt.