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Fed’s Spillovers And Periphery’s Spillbacks: New Game In Town?


On December 15, the WSJ Dollar Index of the currency’s value against 16 major trading partners hit a 14-year high. The Fed’s hike prompted the worst selloff for developing countries since Donald Trump’s presidential victory last November. In a few words, we saw the replication of last year’s turbulence in the wake of the Fed’s first rate hike in eight years.

Emerging-markets’ currencies and assets experienced the Fed’s dollar spillovers, with exchange rate devaluation crossing South Korea winning to India’s rupee.

In China, fears that a rising dollar somewhat destabilized trading in the RMB, sent the currency to its lowest against the dollar in over eight years. Meanwhile, Chinese bond yields soared and authorities halted trading in some futures contracts for the first time, as a global bond-market selloff worsened

Undeniably, the 2016 movie is a validation of Helen Rey’s “dollar global financial cycle”, where she argues for its potency that disables EMEs standard macroecononics tools, and quash the EM central banks’ monetary policy in the rush to shield national currencies and financial stability.

Notwithstanding the above downsides, the potency of the Fed’s spillovers seem increasingly less virulent when compared to those experienced in past episodes (IMF 2015). According to BIS analyses, spillovers have been generating spillbacks to advanced sovereign bond markets through almost synchronized drawdowns of FX reserves.

For the size of these actions, Jamie Caruana of the BIS writes tha,t “reserve managers sales of government bonds in the SDR currencies could rival, or even surpass, the scale of ongoing purchases by the ECB and the Bank of Japan”, and even so as “EMEs’ sales of bonds held in their reserves take place mostly in dollars and ongoing central bank purchases are in euros and yen, these effects compete in a global bond market”.

Actually, spillbacks “to advanced economies from EMEs ownership of specific advanced economy assets, such as sovereign bonds, have increased. The reduction in holdings of US bonds was arguably one factor contributing to moves in US yields over the past year[2015]” ( BIS 2016:57 ).

As a one-time change, this is striking, and as a directional shift, the longer term implications are huge. It’s a matter of fact that EM central banks are growing-up, and are more able at weighing more independent and discretionary policies, including a functional use of their countries’ riches.

In this new trend should be read gold purchases, and the redeployment of FX reserves in a more functional portfolio-like model.

Gold purchases, a long time vexata quaestio in economics, has recently gained momentum and legitimacy. Kenneth Rogoff has made a strong rationale for EMs central banks purchasing gold and exiting from overweight dollars’ FX reserves. EMs as a group, Rogoff writes, “Are competing for rich-country bonds, which is helping to drive down the interest rate they receive. With interest rates stuck near zero, rich-country bond prices cannot drop much more than they already have, while the supply of advanced-country debt is limited by tax capacity and risk tolerance”, so, he argues “a shift in emerging markets toward accumulating gold would [push up interest rate on rich-country bond and] help the international financial system function more smoothly and benefit everyone” (Rogoff 2016).

Actually, EM central banks, for securing FX reserves since they have massive dollar debts and want to reduce their dependence on the US dollar, are going to gold purchases. China and Russia over the past two years accounted for nearly 85% of gold purchases by central banks in a move to diversify reserves, while demand from other central banks has declined. Russia’s gold reserves increased by 45.8 tons in the first quarter 2016, 52% higher than first quarter 2015. China bought 35.1 tons of gold from January to March of 2016. That was in addition to the 103.9 tons it purchased in the second half of 2016 (IMF 2016).

In Asia, some 60 countries along the New Silk Road Belt and the 21st-Century Maritime Silk Road identified as important reserve bases and consumers of gold are originating a new way to use their savings have invested in the China-led Shanghai Gold Exchange (SGE) fund. Expected to raise an estimated 100 billion RMB ( $16.1 billion), the fund seeks to assist a growing number of Asian central banks keen to diversify away from US and European assets in their foreign exchange reserves, and to increase the influence of RMB in gold pricing by opening the domestic gold market to international investors.

Though, its epicenter is mainly in Asia, the SGE is a game changer for the relevant implications on developed economies, especially the US-Treasury bond and German Bund.

Several critical intervening variables are drastically reducing the past FX reserves glut, and reserves managers are exploring a better, and more functional use of reserves’ allocation. The Donald Trump Administration, with TPP and TTIP trade deals put on ice, hints among other things to the end of US as the importer of last resort.

China’ s rebalancing towards domestic demand and services, and the ongoing monetary and financial liberalization no more need large FX reserves, and mostly US T-bonds.
In oil rich countries, the collapse of oil prices, and increasing budget deficits are unlikely fostering any return to previous highs, and, the US policy energy independence reduces petrodollar recycling.

As EMEs will face reduced exports to advanced economies, and they will have fewer dollars left to employ in purchasing US T-bonds, where are EMEs likely to reallocate their countries assets?

The strong commitment expressed by China’s leadership at continuing free trade, and the China-led large infrastructures’ investment deals in Asia and elsewhere should speak for EM central banks to put their moneys where the mouths are, clearly in the RMB.

Yet, for EMEs’ reallocating FX reserves into RMB it would be necessary that China ensures the ability and willingness to retain control over its currency’s depreciation. On this count China should fix the RMB foreign exchange rate policy, and avoid the steady devaluation started in August 2015 through 2016, which has trimmed down the currency value to the one in 2008 against the dollar.

Spillbacks from the periphery to the core central banks hint to a critical turn in international finance.

In 2014, at the height of China’s rush to its FX reserves buildup, Alan Greenspan anticipated that a redeployment of “ even a relatively modest part of China’s foreign exchange reserves into gold, the yuan[RMB] could take on unexpected strength in today’s international currency system. Buying gold bullion to displace the US from its position as the world’s largest holder of monetary gold, China would likely incur a penalty for being wrong, in terms of lost interest and the cost of storage. Yet it would be a modest cost, if in the end this clears the way to a multiple and more balanced international monetary regime, less at the mercy of U.S. domestic objectives”.

*Miriam L. Campanella, University of Turin. Senior Fellow ECIPE Brussels. This article has been edited from a version that appeared at China Policy Institute.

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