With persistently strong demand for Swiss francs, Switzerland continues to face a deflationary environment. The CPI number once again came in negative, justifying Zurich's defense of the EUR/CHF peg.
Swiss CPI (YOY)
We know from Japan's experience that once deflation sets in (and deflationary expectations become part of the public's mind set), it is notoriously difficult for the central bank to fight. Switzerland simply can not afford to allow the Swiss franc to appreciate any further. In defending the peg the Swiss National Bank has to keep buying euros, raising its foreign currency reserves (which hit a new record) as the flight of capital into Switzerland (mostly out of the Eurozone) continues.
Swiss foreign currency reserves (latest number is CHF365bn; source: Bloomberg)
Bloomberg/BW: - Switzerland saw its foreign currency reserves balloon by 66.2 billion Swiss francs ($69.5 billion) over the past month as the country's central bank spent heavily to prevent its currency from appreciating against the euro, according to data released Thursday.
The franc is considered a safe haven for investors concerned about the euro-zone debt crisis.
The Swiss National Bank held foreign currency reserves worth 303.8 billion francs in May, an increase of 28 percent from the 237.6 billion francs in April.
"A large part of the increase in foreign currency reserves between the end of April and the end of May can be traced to the purchase of foreign currency to enforce the minimum exchange rate," said SNB spokeswoman Silvia Oppliger.
Indeed we had a big spike in foreign currency reserves of the Swiss National Bank in May.
SNB foreign currency reserves (CHF MM)
And this was in fact caused by the SNB defending the 1.2 level on the EUR/CHF (euro/swiss) exchange rate - selling CHF and buying EUR (to keep CHF form appreciating too much). The reason the SNB had to do such a massive volume in FX transactions is that the euro area citizens are flooding Swiss banks with deposits (buying CHF and selling EUR). As Kostas Kalevras points out, the ECB's foreign reserve liabilities shot up €77.5bn in May to accommodate this transfer to Switzerland and to other non-euro countries. This confirms that not only do we have a run on periphery banks, with cash moving to Germany, but deposits are rapidly moving abroad as well. And Switzerland has become the main beneficiary (more on that later).
Central Banks globally have been reducing their holdings of the euro as a reserve currency. Several years back it looked as though the euro was on a path to replace the US dollar as the dominant component of global foreign reserves. But with the start of the Eurozone crisis the euro's attractiveness as a reserve currency waned.
Central banks invest a great deal of their reserve currency into asset denominated in that currency, usually government bonds. The amount of government debt in the Eurozone that central banks feel comfortable holding has diminished markedly since the start of the crisis. There is only so much that India, China, Brazil, etc. can invest in bunds, just given the the overall size of the German government market. The universe of "safe" (by central bank standards) bonds outside of Germany has become limited.
Barclays Capital: The attractiveness of the EUR as a reserve currency has decreased as there are
increasing doubts over the stability of the monetary union. The risk of future sovereign
restructurings will likely reduce foreign demand for European government bonds and an
increasingly fragmented bond market also raises questions over the EUR’s status as a
reserve currency. This is reflected in the reduced size of flows into the EUR over the
past few quarters and in our view will be a medium-term negative for the currency.
% allocation of global central bank reserves by currency (Source: Barclays Capital)
The beneficiaries of this rotation have been the US dollar as well some of the less traditional reserve currencies such as AUD, CAD, etc. As Barclays points out, this trend is likely to continue over time, further reducing demand for Eurozone government debt. The one possible action by the Eurozone that can stem this decline would be the creation of the Eurozone Bond that has "joint and multiple" guarantees of the member states. That would create an equivalent of the US treasury market giving central banks more room to increase the EUR reserves. But for now the possibility of such action seems extremely remote because it would require significantly ratifying the EU Treaties.
There has been talk that some Eurozone nations may or should sell their gold reserves in order to pay down a portion of their debt or cover certain new debt they are unable to sell. Part of the rationale for this line of thinking is the fact that gold constitutes a large portion of many nations' total reserves. For example Italy's gold holdings make up 71% of the nation's reserves, while Greece's gold position makes up 83% of its reserves.
Unfortunately these gold reserves are a drop in the bucket compared to these nations' outstanding debt. Italy's $130bn worth of gold is 6% of their total debt outstanding (which is actually higher than it is for the US). For Greece that number is closer to 1%. Selling these reserves would provide little relief for these nations and only on a temporary basis. It is therefore unlikely we will see any substantial sales of gold by Eurozone governments.
As the dollar continues to get clobbered (chart below), it is helpful to see what central banks are doing with their reserves. This is particularly useful because central banks don't trade currencies (at least they are not supposed to), and the allocations are often indications of longer term policies/trends.
source: Bloomberg
A recent release from IMF shows the following allocation picture as of the end of Q2 (this is on a quarter lag, but still useful):
source: IMF
And here is the Q1 to Q2 change in the amounts allocated to each currency (shown as percent change from the Q1 allocation amounts). Note that the Swiss Frank (already a small allocation) continues to drift down as central banks begin to see Switzerland as too leveraged to it's financial services industry.
source: IMF
Looks like some allocation to the USD continued in Q2, but allocations to EUR, JPY, and other currencies have increased much more. That makes USD a smaller percentage of the overall foreign reserves. In fact the USD percentage has dropped to a record low of just under 63%. And that is looking more like a trend.
source: Bloomberg
If the trend continues, it will become particularly difficult for export focused nations such as Japan and Germany. Given the size of foreign reserves (foreign exchange holdings are now at $6.8 trillion), even small reallocations to EUR and JPY will cause sizeable currency appreciation.
The People's Daily (the government sponsored newspaper) published a blurb a couple days ago called "China massively offloads U.S. debt holdings first time in 2009". Readers around the world particularly focused on the word "massively". Given that this publication is censored, there must be a message there. Some in China heralded this as a sign of China's new strength. Is China retaliating for the recent US trade victory in WTO ruling? Some believe it's a form of intimidation - trying to spook the Obama administration into compliance on trade issues.
Yin Zhongli, a senior researcher with the financial research institution of the Chinese Academy of Social Sciences, believes that the share of US dollar-dominated assets in China's foreign exchange reserves is too large.
"So, we have to diversify our portfolio for risk aversion," Yin said, adding that the country might buy more assets denominated in other foreign currencies, such as the euro, the Japanese yen and the Australian dollar.
One would think in order to diversify reserves, China can simply sell their dollar cash holdings and buy some Yen, Euro, or AUD instead of selling notes. But there is no evidence that China is in a hurry to do much of that. What's really going on?
The reality is that it simply doesn't matter. So they sold some notes and let some bills mature without reinvesting them. This change and even a larger sale by China will have a very modest effect on the treasury market. The chart below shows just how immaterial the "China massively offloads" action really was in the larger scheme of things. The foreign holdings of US Treasuries continues to grow even as China is moderating it's holdings.
China simply has little choice in the matter. Allocating $2.13 of China's foreign reserves will roughly get them to the same place every time - they have to keep a significant part of it in dollars (currently estimated to be at 70% of the reserves) and they have to hold US debt. The rapidly growing supply of US debt is clearly an issue, but the alternatives for them are no better. Many of the markets that have some depth to them such as UK gilts or JGBs carry as much or more risk than the US government debt.
The significance of this reduction in China's holdings is simply overblown.
In a recent post called Pegged renminbi will be hard to internationalize, we discussed the issue China faces as it tries to maintain it's export based economy. It does so by holding the currency artificially low to make their product look cheaper to the world. To accomplish this, they must continuously purchase dollars, while selling renminbi. But where do they get the renminbi to sell?
Well in what's called an "unsterilized" FX transaction, China simply "prints" the new renminbi to sell (as opposed to a "sterilized" transaction where the central bank sells currency spot but agrees to buy it forward, thus not impacting the money supply.) The newly "minted" renminbi sold by the central bank for dollars simply gets deposited in it's banking system, increasing the money supply. This is how they keep the currency from shooting up 30%. It's a dangerous game, because all that new renminbi deposited in Chana's banks has to go somewhere.
With the money supply growing rapidly, China could raise interest rates to control inflation. But if they do so while the USD rates are nearly zero, it will put even more upward pressure on their currency. If you have an asset at par with the dollar that pays higher rates and can only go up in value, you'd be buying as much as you can. So as long as Western rates remain low, China has to keep their interest rates relatively low.
Banks in China are lending and will continue to lend at least some of those excess deposits. Thus unlike in the US, where banks are in the process of repairing their balance sheets, China has what's called a multiplier effect going.
According to recent research from HSBC, this phenomena of artificially low currency values and local banks that are able to lend is prevalent across the exporter nations of Asia. This stimulus will create a tremendous asset bubble across the region (particularly in equity prices and real estate.)
If people fear that all the stimulus in the US will create inflation, think about countries with a real multiplier effect. Given that the US, and Europe will keep their rates low for a while, by the time the stimulus in Asia is taken away, the bubble momentum will be unstoppable.
From HSBC: Asian policy rates - have to stay low as long as Western rates stay low
From HSBC:
The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.
Credit continues to grow in Asia with no major slowdown due to the crisis.
From HSBC: Credit growth across Asia
At the same time deposit rates are growing as well, driven in part by the "unsterelized" currency interventions that force dollar sellers to deposit the currency proceeds in that country's banks.
Deposit growth y-o-y
Deposit growth and credit expansion accelerate the monetary base growth.
Base money growth y-oy:
All this translates into loose monetary conditions in Asia that lead to an asset bubble:
The Monetary Conditions Index; y-o-y
Expect corporate leverage, property, and equity price levels to balloon to dangerous levels as liquidity continues to grow unabated throughout Asia. This is the next big bubble.
