Case studies in exchange rate management

“Czech Foreign Reserves Jump to Record as End of Koruna Cap Nears”

“China Reserves Edge Below $3 Trillion as Yuan Pressure Increases”

Bloomberg Headlines, February 2017

When considering the outlook for economic liquidity, and also the prospects for that country’s currency, one key metric to consider is the trend in foreign exchange reserves. A variety of inputs drive the change in a country’s foreign exchange reserve level, including the trade balance, both inbound and outbound foreign direct investment (FDI) and portfolio investments, and other capital movements. It is difficult to be prescriptive about what the implications are of any particular change in reserves, but increasing reserves generally mean better liquidity (through lower interest rates, and/or faster growth in money or credit aggregates) and upward pressure on the currency, while decreasing reserves generally indicate increasing economic stress.

Where policymakers in an emerging market seek to manage the exchange rate, foreign exchange reserves become very important. A macroeconomic effect called the ‘impossible trinity’ says that a country can only choose to have any two of free capital mobility, a managed exchange rate and an independent monetary policy. In a world where all capital accounts are to some degree open, this effectively leaves a choice between controlling the exchange rate and controlling monetary policy. In light of this, it is interesting to consider two very different sets of economic circumstances in emerging markets.

China’s foreign currency reserves fell below the psychologically-significant US$3 trillion level in January, representing a fall of almost US$1 trillion (!) from the June 2014 peak. With China’s credit boom continuing to increase the size of the banking system and the renminbi monetary base, an increasing number of market participants have chosen to send cash offshore or invest overseas, resulting in downward pressure on the renminbi as these entities sell renminbi to buy US dollars (or equivalent).

To manage the exchange rate without putting up interest rates, the Chinese central bank, the PBoC, has been intervening more and more aggressively, using its own stock of foreign currency to buy renminbi and support the exchange rate. This is where that US$1 trillion has gone. The decline in reserves in January was particularly pronounced as the PBoC sought to push the renminbi stronger through this kind of intervention.

Ultimately, though, as long as China’s leadership targets a 6.5% real GDP growth rate, large increases in credit and money aggregates will be needed, and the downward pressure on the renminbi will continue. Total credit in the economy has risen from 200% of GDP to 250% in the period where reserves fell from US$4 trillion to US$3 trillion. There is no immediate catalyst for a crisis, but the current trend would see credit/GDP at 300% and FX reserves at US$2 trillion by early 2019, which would both seem to be unsustainable levels. With our medium-term investment horizon, we expect a renminbi devaluation, and are heavily underweight China in our portfolio.

Meanwhile, the Czech Republic faces the opposite problem. Determined to prevent the Czech koruna appreciating against the euro, the central bank (the CNB) has put a floor in the exchange rate. Capital is flooding into the country, despite near-zero interest rates, with foreign exchange reserves having nearly doubled in the last two years. The January increase in reserves alone was US$18.2 billion, or 7.5% of GDP. Despite macro-prudential intervention to control the banking system, inflation is now picking up, and, like the PBoC, the CNB will have to give way at some point – only in this case by allowing the currency to appreciate. We see this as a highly positive environment and have initiated a portfolio position in the Czech Republic.