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Central banks prepare to flood FX markets with euros
[LONDON] Central banks keen to steer clear of negative-yielding assets in a rapidly depreciating currency could cut the foreign exchange reserves they hold in euros by a hundred billion dollars or more, analysts estimate.
The near year-long slide in the euro and the move below zero of many eurozone government bond yields has driven a shift by official institutions, among the world's most conservative investors, on how they manage their US$11.6 trillion of FX reserves.
Several analysts, mostly in conjunction with bearish forecasts on the euro, said they expect central banks'euro-denominated reserves to fall below 20 per cent of overall holdings over the coming quarters from around 22 per cent.
A continued decline in the euro's value against the dollar will account for much of that, but outright selling could still run into a 12-figure sum - a significant flow out of the single currency and a major force for further weakness.
"This shift could amount to as much as US$104 billion per year," according to estimates from Goldman Sachs.
The latest International Monetary Fund data show that global FX reserves fell by 3.1 per cent, or US$383 billion, in the second half of last year to US$11.6 trillion. Around two thirds of that was due to valuation effects from the euro's 11.7 per cent fall in that period, according to JP Morgan.
The euro's share of all reserves fell to 22.2 per cent, the lowest since 2002.
Stephen Jen, manager of the SLJ Macro hedge fund in London, reckons that will fall by a further 2-4 per centage points in coming quarters, equating to a reduction of roughly US$240-US$480 billion.
About half of that would be valuation effects and half active divestment, meaning central banks could be dumping euro assets worth up to US$240 billion onto the market.
"Reserve divestment from the euro will be powerful," Jen said. "Central bank reserve managers don't like negative yields."
The European Central Bank's commitment to flood the financial system with over 1 trillion euros through an 18-month long bond-buying programme to choke off the threat of deflation has had an instant and massive impact.
The euro has tumbled towards parity with the dollar and bond yields across the region have sunk to the lowest in history, in many cases below zero.
Declines in global FX reserves are rare.
The fall in the second half of last year was the biggest since the global financial crisis, and the sixth largest in nearly 50 years, according to JP Morgan.
Most of the last 20 years have seen a rapid rise in exports from emerging market and oil-producing countries to the developed world, resulting in huge dollar inflows which have been banked into FX reserves.
Reasons for the recent shift away from that pattern include: the plunging oil price, the euro's sharp depreciation; slowing growth in emerging markets; and many of those countries drawing down reserves to prop their currencies up against a rampant dollar.
Ordinarily, these central banks might have had difficulty in finding a buyer for their depreciating euro assets. But with a third of the euro zone government debt market trading with a negative yield and the ECB just a month into its bond-buying spree, these are not ordinary times.
The ECB has so far bought 61.7 billion euros of bonds. It's unclear how much, if any, of that has come from other central banks as trades would be done via third parties.
Foreign exchange reserve managers typically hold short-term, low-risk, high-quality assets such as AAA-rated sovereign bonds, around 2 trillion euros of which currently boast a negative yield.
But this doesn't necessarily mean holders of these assets are losing money, as the coupons offered may still nominally be positive. But the returns are negligible, so it's no surprise some central banks have had enough.
"If you're sitting on bonds at these yields, and if you have a large non-commercial player coming in to buy, it's time to sell," said Philip Laine, Whately professor of political economy at Trinity College in Dublin. "The question is what do you recycle into?"