Is the euro in safe hands?

23 August 2019

Mansoor Mohi-uddinMacro Strategist, NatWest Markets

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In the past, the People’s Bank of China had the potential to alter the euro’s direction, but this looks set to change. Here we explain how and why, as well as where the euro might be heading as a result. Some of the answers are enlightening – and surprising.

The euro owes its current predicament to policy decisions taken thousands of miles from the ECB’s Frankfurt headquarters. That’s because over the last couple of decades, the People’s Bank of China (PBoC) has had the potential to change the euro’s direction through diversifying the massive foreign exchange reserves (FX) managed by its State Administration of Foreign Exchange (SAFE).

From around US$200 billion at the turn of the century, SAFE’s foreign currency holdings ballooned to a peak of almost $4 trillion in 2014 – at the time accounting for one third of the world’s $12 trillion total FX reserves. It was rapid, too. During the years of large-scale reserve growth, that FX accumulation by the People’s Bank of China’s sometimes exceeded $100bn per month.

This gave SAFE the capacity to be the marginal buyer of euros in the currency markets through diversifying new dollar holdings.

If, for example, in the months when the PBoC’s FX reserves increased by $100 billion, SAFE had immediately sold $25 billion for euros, then its flows could have far surpassed European exporters’ dollar sales. In fact, only in 2014 did the Eurozone’s monthly trade surplus reach $25bn for the first time.

Let’s look at the data: Every trend comes to an end

But this is where things may be set to take a different turn. Because all the available public data suggests China’s central bank isn’t likely to be the marginal buyer of euros anymore. Let’s take a look at what’s happening here.

1)     No more fresh reserves for the People’s Bank of China – China reserves data

First, the People’s Bank of China hasn’t been accumulating fresh reserves since the start of 2017, removing the immediate need to diversify out of new dollar holdings. SAFE could still decide at any time to shift the composition of its remaining $3 trillion of FX reserves but there appears little evidence of any large-scale diversification out of dollars into euros by China’s reserve managers at present.

2)     No new shift towards the euro – IMF COFER data

Add to this, the fact that the International Monetary Fund’s (IMF) Currency Composition of Official Foreign Exchange Reserves database (COFER) doesn’t show any major shift towards the euro over the last few quarters amongst central bank reserve managers.

According to the COFER database, the share of the dollar in global FX reserves fell 3.7% to 61.7% between the end of 2016 and the end of 2018. Yet over the same period, the greenback’s value against other major currencies declined by almost 6%[1]. This will have passively reduced the proportion of US assets in global FX reserves, accounting for much of the decline in the greenback’s share in the COFER series over the last couple of years. Indeed, in 2017 and 2018, the time series did not reveal any major shift into euros.

Significantly, this COFER database is now likely to include China’s FX reserves. Since Q2 2015, the People’s Bank of China has been reporting an increasing sample of its reserves. At the end of 2018, all FX reserves covered by the survey had reached $10.7 trillion compared to total worldwide FX reserves of $11.4 trillion.

The IMF’s series is thus likely to represent SAFE’s foreign exchange allocations as well as all other major reserve managers now. The latest COFER report released in June covering Q1 2019 provides the same picture. This implies neither SAFE nor other reserve managers have been sufficiently active to change the direction of the euro over the past couple of years through dollar diversification.

Instead, the share of global reserves held in the single currency has remained stubbornly around 20%.

3)     No significant trend away from US Treasuries – Custody data

Custody data does not show any shift away from US Treasuries and agencies by foreign official investors. For example, the Federal Reserve (the Fed) publishes weekly data on the amount of US portfolio assets it holds in custody accounts for foreign central banks and multilateral agencies. And it doesn’t indicate any significant trend away from US Treasuries by foreign reserve managers this year.

Stick or twist for China and the US dollar?

Swap line commitments are another key factor in why the People’s Bank of China are shifting gears away from euros. A swap line is an agreement between central banks for overnight and short-term lending of currencies. China’s swap line commitments therefore allow foreign central banks to exchange their domestic currency for Chinese yuan.

However, China’s central bank has announced swap lines with 34 counterparties around the world, currently totalling almost 3.7 trillion Chinese yuan. This is a significant amount of swap lines, and may be why the People’s Bank of China are keen to stock pile dollars, rather than diversify into euros.

The risk that yuan proceeds could subsequently be sold on for other foreign currencies like the dollar – putting downward pressure on China’s exchange rate – suggests the PBoC will likely want to hold FX reserves denominated in greenbacks to counter such contingencies in future. Already the swap lines total almost $550 billion in US dollar terms.

Eurozone attractions

And what of the euro itself? Asian central banks are set to stay underweight euros while short-term Eurozone government bond yields remain below zero. Reserve managers in the region are largely prohibited or strongly discouraged from buying negative yielding assets. Thus central banks in Asia are likely to be underweight euros in their reserves given short-term government bond yields across the Eurozone (with the exception of Italy’s) have been trading below zero since 2015. Until the European Central Bank starts lifting its -0.40% deposit rate and induces short-term bond yields in the Eurozone to turn positive, reserve managers may stay underweight euros in their portfolios.

The bottom line

Historically, the People’s Bank of China has had the potential to alter the euro’s direction through diversifying its massive dollar holdings. But the available public data suggests China’s central bank isn’t likely to be the marginal buyer of euros anymore. The latest data from the IMF’s COFER survey implies neither SAFE nor other reserve managers have been sufficiently active to change the direction of the euro over the past couple of years through dollar diversification. Add this to the fact that the Fed’s more timely weekly custody data isn’t signalling foreign reserve managers are selling US Treasuries aggressively.

The result? A strong shift away from US portfolio assets into euros may not occur until the ECB starts raising its deposit rate from negative territory.

Monetary policy
FX
People's Bank of China
US Federal Reserve
Eurozone


Footnotes:

[1] When using the dollar index DXY

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