FX market intervention by central banks

UPDATE: The Wall Street Journal just commented on the rumors discussed below in the article “SNB in strong position to raise Euro floor“. The piece argues in favor or raising the floor in order to stimulate export led economic growth. It does not comment on the issues I raise below, and my view remains unchanged. A higher floor may not cost the SNB much at the moment, but by pushing the exchange rate further from its underlying value, the potential profit from holding the CHF when the peg breaks becomes greater, thus attracting more flows into the Swiss Franc (see graphs below).

Central Banking, or monetary policy, can at times be surprisingly exciting. The Swiss National Bank (SNB) and the Hong Kong Monetary Authority (HKMA) both have made some bold moves in the past and at present. The HKMA was arguably the most successful central bank to resist the extreme pressure on Asian currency pegs during the Asian crisis. This defense did not merely include purchasing its own currency to support its value, the HKMA is also believed to have intervened directly in equity markets. At the peak of the crisis in October 2007, they supposedly purchased vast amounts of equities where short sellers were trying to profit from a double bet on a weaker HK$ and lower equity prices in the crisis expected to follow. The end result was a great victory to the HKMA, and an expensive defeat to the shorts. (A great book about this particular event is Intervention to Save Hong Kong: Counter Speculation in Financial Markets by Goodhard and Lu.)

Given the HKMA’s track record in FX intervention, one should perhaps not be surprised that they are again intervening (this time in a conventional manner) to defend their peg to the US dollar. The difference is that this time the market is pushing the HK dollar up and the HKMA intervenes to weaken its currency. According to Reuters, the HKMA sold 6.2 billion HK dollars today (Tuesday 11 dec) in the open market (800 mill USD). This came on top of an additional 1.5 billion HK $ sold since October 2012. It should be noted that defending currency weakness is much easier than defending its strength. The HKMA can sell as many HK$ as its heart desires, the only consequence being a growing portfolio of foreign reserves. However, at some point printing too much of your own currency may be problematic. The Swiss National Bank may soon learn this lesson.

The market chatter today has spread a rumor regarding a potential raising of the CHF-EUR floor. In 2011, the SNB unexpectedly (and somewhat controversially) imposed a floor on the Swiss Franc’s exchange rate to the Euro at 1.2 CHF/EUR. A higher floor would imply a weaker CHF, thus profits for the shorts and loss for the holders of CHF. The source of the rumor is unclear, and very little if any has been written about this. Some seem to think is is caused by a recent recommendation by UBS warning its clients against holding large amounts of CHF. In other words, they see a risk of CHF depreciation. Personally, I don’t see this to be a significant risk at the moment. The SNB is already forced to expand its foreign reserves (by printing CHF) at an extreme rate in order to defend the artificially weak exchange rate (see figure below).

This is a clear sign that market forces alone are not going to let the CHF depreciate. The only way this can happend is via SNB intervention such as raising the floor to, say, 1.25 CHF/EUR. But why would they do this?

The reason would be to support its exporters and stimulate growth. But the SNB has already forecasted positive inflation in 2013 (albeit conditional on their policy, which may potentially include such an intervention). And the benefits of a slightly weaker CHF will not necessarily justify the risk they take. The money base has exploded and this growth cannot be sustained indefinitely. Based on this picture (see below), one would rather expect the SNB to be forced to abandon its floor rather than raising it. Of course the SNB will not comment on rumors like these, because the rumor works very much to the benefit of the SNB. The more traders expect the CHF to weaken, the less CHF the SNB needs to print. The SNB would in fact benefit from spreading rumors like these, then lean back and let the short sellers to the job for them.

Data referred to above is available here on the SNB Statistics website.

Some additional sources for more information:

HK moves again to halt currency rise – FT.com

South African Reserve Bank Quarterly Bulletin: Foreign Financing Still Strong in Q3

THE LAST South African Reserve Bank (henceforth ‘SARB’ or ‘the Bank’) Quarterly Bulletin for 2012 was released today. The main story is a low GDP growth rate (1.2% annualised) cut in half compared to the preceding quarter. The blame for this goes to the violent strikes in the mining sector and its spillovers into other industries. On this blog I will aim the focus on what the bulletin has to say about cross-border capital flows.

The South African consumer demand is still strong, but SA manufacturing is struggling to keep up. Hence, a continued current account deficit of 6.4%, similar to the second quarter. This deficit was funded by financial inflows that were still strong in Q3 (if this will last into Q4 is unclear given the net non-resident portfolio outflows in October). The SARB explains portfolio inflows in Q3 by international bond investors attracted to a favorable interest rate spread against advanced economies. My personal opinion is that these flows are more likely to be explained by the lower price of risk and / or higher risk appetite in the same quarter (the VIX averaged 17 in the quarter, compared to 18 in the year to date, or 22 since January 2010). This low price of risk is possibly caused by the highly accommodative monetary policies in Europe and the US, and thus correlated to their interest rate differential with South Africa. Thus, one would expect easy monetary policy in these countries to increase flows to SA, but it is a tricky task to determine whether it is via the price of risk or carry trade profitability.

Increased direct investments in the third quarter is explained by the Bank as foreign investors (companies) increasing their equity stake in existing investments and by parent companies extending loans to South African subsidiaries. Current research (eg Shin and Bruno 2012) would suggest that such lending is also a product of lower price of risk globally and low policy rates in the source economies. The recent depreciation of the rand will make these loan porfolios more risky if they are extended in terms of the creditor’s currency, and will adversely affect their willingness to provide further loans to SA business. The Bank explains the weaker rand by labor unrest and illegal strikes, downgrading of Sovereign debt, rising trade deficit and upwards pressure on inflation.

My prediction is that South Africa’s trade balance will remain unchanged in Q4, but demand for South African assets (and indirectly the rand) will fall short of current account deficit at the current exchange rate. This will require a further rand depreciation to allow South African’s to maintain their current consumption level. Given the low growth rate in Q3, one may have reason to hope that the Bank does not respond to rand induced inflation pressure by raising rates.

The full bulletin is available here on SARB’s website.

Cross-Border Banking: ABSA now Barclays Africa Group Limited

It is an important event for anyone following cross border banking flows in Africa (for all I know, I am the only one), when Barclays proposes to increase its stake in one of the largest banks on the continent to 62.3% in return for most of its other current African operations (where its stake will drop from 100% to 62.3% through its ABSA stake). With this increased ownership they will also change the name from ABSA Group Limited to Barclays Africa Group Limited. In the transaction, ABSA will take full ownership of what is now Barclays Africa Limited and thus take over Barclays’ current operations in n Botswana, Ghana, Kenya, Mauritius, Seychelles, Tanzania, Uganda and Zambia and the Barclays Africa Regional Office in South Africa. As such, the transaction does not immediately imply a predictable change in capital flows between London and Africa. However, the strategic implications of the deal indicate a clear vision for future growth of Barclays’ African portfolio.

The strategic reasoning behind the transaction is to strengthen Barclays’ and Absa’s goal of becoming the “Go-To” bank in Africa as part of their “One Bank in Africa” plan. The ABSA announcement states

Investors will gain exposure to several attractive countries, where high forecast GDP growth and under-penetrated credit, capital and insurance markets should produce strong growth in their banking-related revenue pools. The combined operations will also be able to leverage an integrated operating model across the continent, while enhancing collaboration on product innovation.

A question of interest in this regard is to what extent Barclays Africa Group intend fund its operations through customer deposits in the host country, or through cross-border lending from South Africa or the UK. This of course depends on the rate of growth of deposits and credit in the respective African countries, which will be the ultimate determinants of the volume and direction of future cross-border bank flows.

The frontier academic models of cross-border bank flows (largely developed by Prof. Shin at Princeton University), would suggest that such flows are sensitive to monetary policy and money market rates in the UK, in addition to risk appetite (or the price of risk). Flows into African countries should have the expected appreciating pressure on their currencies, which makes the current loan portfolio less risky (in Sterling terms) and may induce further flows as the marginal loans become profitable. Thus, increased foreign bank presence (through subsidiaries or directly) in Africa should therefore see the African currencies strengthen in response to cheap money in Europe and the US and / or low price of risk.

Read more about the proposed transaction here:

MoneyWeb: Barclays and ABSA to combine most African operations

Bloomberg: Barclays agrees $2.1 billion ABSA deal

The full announcement from ABSA is available here.

A view on Capital Flows: IMF changes its mind

YESTERDAY the International Monetary Fund (IMF) adopted its reviewed institutional view of Capital Flow management and policy. An FT editorial more or less praises this “U-turn” by the IMF. The FT says:

“On Monday, after a thorough three-year review, the fund has accepted institutionally that direct controls can play a useful role in calming volatile, international capital flows […]

As the IMF rightly argues, the first line of defence against financial instability should always be more conventional macroeconomic tools. When an emerging market is facing a precipitate inflow of hot money, cutting the interest rate and tightening fiscal policy can be more effective than direct controls.”

Initially this view seems very easy to agree with. However, I suspect that a problem for many emerging markets will be the fact that domestic conditions and economic policy does not play a major role in the decision making of global investors. American and European banks buy South African assets because they look for EM exposure, not necessarily because the yield is high. It is very difficult to find statistical evidence that higher policy rates in SA have increased non-resident purchases of SA bonds. On the other hand, the one consistently significant explanatory variable of all non-resident purchases of SA assets is the VIX (the current situation seems to be an anomaly) . That is, capital flows to SA when global risk is low (or risk appetite is high). In such a scenario, a lower policy rate will not do much to reduce this flow of capital.

My favorite current academic research on the topic of global capital flows is being done by Hyun Song Shin at Princeton University. He has presented his observations at multiple conferences, including the 2011 High-Level Conference by the Brazilian Authorities and the IMF on Managing Capital Flows in Emerging Markets. In the audience at this conference sat Dr. Olivier Blanchard, Economic Counsellor and Director of the Research Department of the IMF. In a blog post Dr. Blanchard summarized what he took away from this conference, here is a selection of his notes:

None of the tools—be they reserve accumulation, prudential measures, or capital controls—are water-tight. So we should move away from strict policy orderings toward a more fluid approach of using “many or most of the tools most of the time” instead of “this now, that later”.

This lesson seems to have made an impression on Dr. Blanchard, as it nicely summarizes the general feel of the new institutional IMF view published now (more than a year later). Unfortunately Dr. Blanchard does not mention what lessons he took from Prof. Shin’s presentation. Shin’s research has pointed out that many of these capital flows are in fact caused by cross-border banking: A US or Europe based bank lending directly to emerging market clients, or through a local affiliate. Shin’s model predicts that these flows will be determined by US monetary policy and the VIX (price of risk). The model does not allocate any role to domestic policy in the recipient country other assuming capital flows are completely liberalized.

Such a view does not correspond well to the notion that domestic interest rates can be influential in affecting EM capital flows. In that case, if capital flows are deemed to be too costly (risky), regulation may be the only option. Regulation can effectively reduce or stabilize capital flows into a country, but they carry a substantial cost in terms of lost efficiency, competitiveness, and diversification of idiosyncratic country risks. I personally tend to support the idea of liberal capital flows with monetary policy focused on the domestic economy: that is – raise rates when the economy is overheating, even if the overheating is caused by capital inflows.

Monthly Update: Non-Resident Purchase of Bonds and Shares in South Africa

FRIDAY 30 Nov, the South African Reserve Bank published the October numbers on non-resident purchase and sales of South African bonds and shares. The most notable development in this release was a further acceleration of net equity sales on the JSE by non-residents (highest since January this year). Rand weakness in October (see bottom chart) was clearly a consequence of this selling. October was the fifth month in a row with increased net selling of South African equities – a reflection of the international investors’ perception of the SA economy. In ordinary times one would see SA capital flows be driven by global risk appetite. But with the exceptionally low and steady level of the VIX in recent months, one can hardly explain this divestment in SA equities as a risk-off scenario. Rather, this appears to be SA specific, potentially caused by global media attention surrounding violent strikes in the country.

Net bond purchases by non-residents are still positive, but lower than previous months and may soon follow equities into negative territory if the global media continues with its bleak reporting of SA conditions. The total of net bond and share purchases was negative, indicating a net outflow of capital held by non-residents. This net selling of SA assets was indeed the highest since September 2011. However, as can clearly be seen below, the September sales last year were not caused by SA specific reasons, but rather global risk aversion (the VIX spiked to above 40 in the same month). Thus, we have to go back to 2010 for a net selling pressure like this, caused by South African conditions. The October Capital Flow Heat Map will rate South Africa as Chilled with Freezing temperatures possible for November.