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31 Mar 2015
Global FX Strategy

COFER Update: EUR allocation hits lowest since 2002, while USD allocation climbs to highest since 2009

  • Official FX reserves have increased six-fold since 2000. However, since mid-2014 the growth rate has decelerated sharply, due to the stronger USD, as well as stress in some emerging markets. In fact, total reserves invested by emerging markets declined for the first time in twenty years.
  • The proportion of disclosed allocations invested in USD assets increased to 62.9% in Q4, the highest percentage since 1Q2009. Before 2008 the USD allocation was declining by about 1ppt annually, but since the financial crisis the proportion stabilized and has recently been drifting higher.
  • The proportion invested in EUR assets declined significantly in Q4, to 22.2%, the lowest percentage since 2Q2002. Further, the decline experienced over the last year was the sharpest witnessed since the EUR’s inception. Prior to 2009 the allocation to EUR assets was on the rise. However, during the last four years this trend has reversed, with the allocation falling by roughly 1ppt per year. Given the depreciation in the EUR in 1Q15, we expect the EUR allocation to decline to 19.8% with the next COFER release. The primary beneficiary is likely to be the USD.
  • Currency depreciation during the quarter caused passive declines for everything except the USD. However, reserve managers swam against the strong USD tide, concerned that FX movements were driving non-USD allocations below target. Net of currency effects, they were significant buyers of CHF and JPY, and moderate buyers of GBP, CAD and AUD. However, they allowed the weaker EUR to drive that allocation lower, pretty much unresisted. This reflects medium-term concerns regarding their prodigious exposure to the common currency.
The IMF’s COFER report for 4Q2014 shows how allocated FX reserves are invested across seven currencies (plus “others”). Since 2000, official FX reserves have increased sixfold (Table 1) with 62.9% of the allocated total being invested in the USD (the highest proportion since 1Q2009) and 22.2% in EUR assets (the lowest since 2Q2002). In addition to the five traditional reporting currencies, in 4Q12 the IMF added the CAD and AUD to those reported in its quarterly COFER report (Table 2).
Table 1: USD allocation soars, while the EUR’s share plummets (with the rest managed in a tight band)
Official FX reserves and disclosed allocations at year-end for five currencies and “others”
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Source: IMF, J.P. Morgan
* This table is intended to demonstrate the medium-term trend, so CAD and AUD allocations (which were first disclosed in 4Q12) are included in “Others.”
One worrisome trend is that we are flying increasingly in the dark as allocated reserves now constitute only 52.5% of the total. This represents a record low, down markedly from 78.4% in 2000 (i.e., it has been declining by about 2ppt per year). At this pace, by 2016 currency allocations may be disclosed for less than half of global FX reserves. The IMF is rightly concerned about the risk this lack of transparency poses for financial markets.
The Dollar Trap: USD allocation climbs to its highest since 1Q2009
The proportion of disclosed allocations invested into USD assets increased from 60.8% in Q1 to 62.9% in Q4 of 2014. Before 2008 the USD allocation appeared to be declining by about 1ppt per year (for example, from 71.1% in 2000 to 63.8% in 2008). However, since the financial crisis of 2008-09 the proportion invested in USD assets stabilized (fluctuating in a tight 60.7 to 62.5% band) and has recently broken out to the upside. Looking ahead, we expect that the USD allocation increased even further in 1Q2015, given the over 4% appreciation in the broad dollar during the quarter. Beyond 2015, however, a return to the pre-Lehman declining trend seems likely as FX reserve managers remain determined to (eventually) diversify away from the greenback.
Table 2: Quarterly data shows a similar pattern with a rising and disproportionate USD allocation, a declining percentage into EUR assets, and remarkably stable shares for the remaining five currencies
Official FX reserves and disclosed allocations for seven currencies and “others” over the last nine quarters (CAD and AUD were added in 4Q12)
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Source: IMF, J.P. Morgan
The proportion invested in EUR assets plummets to its lowest since 2Q2002
The proportion of allocated FX reserves invested in EUR assets has declined significantly, from 24.3% in Q1 to 22.2% in Q4 of 2014, the smallest proportion in over a decade. Further, the 2.2ppt decline during the last year represents the largest annual reduction in the EUR allocation ever (well, since inception in 1999).
Prior to 2009 it seemed that that the percentage invested in EUR assets was on an inexorable rising trend. More specifically, the allocation was increasing by about 1ppt per year (e.g., it had increased from 17.6% in 1999 to 28.0% in 3Q2009). However, during the last four years this trend has reversed, with the allocation to EUR assets declining by roughly 1ppt annually.
Looking ahead, we expect the EUR allocation to decline over coming years, partially due to currency weakness (we forecast EUR/USD to decline to 1.05 by 4Q15, largely driven by Fed hikes), but more fundamentally resulting from diversification into higher yielding currencies (EUR yields are likely to remain lower for longer, given that the ECB’s QE policy should remain in place well into 2H16).
During 1Q2015 we project the EUR allocation to decline significantly further. First, the EUR/USD declined by about 11% during the quarter. Further, recent COFER releases have demonstrated that reserve managers are not swimming terribly aggressively against the EUR undertow. To a large extent they have responded passively, allowing the weaker currency to drive the EUR allocation lower. Presumably this reflects medium-term concerns regarding their prodigious exposure to the common currency. Consequently, we expect the EUR allocation to decline to 19.8% with the next COFER release.
Net of currency effects, reserve managers were significant buyers of JPY and CHF
The JPY allocation has been remarkably stable, at 4.0% for three consecutive quarters (table 2). Further, the JPY allocation has stayed in an extremely tight 3.8 to 4.1% band since 2012. This strongly suggests FX reserve managers have a target allocation in mind for the JPY. This is demonstrated by table 3 which shows that, when faced with the 10.3% depreciation in the JPY in Q4 of 2014, reserve managers actively increased their holdings. So much so that the net decline in exposure was only 1.4%. They reacted similarly in the previous quarter, when the JPY depreciated by 8.0%, but reserve managers bought JPY assets actively so that their net exposure only declined by only 3.7%, or by less than half the fall in the currency.
Regardless, over time we expect the JPY allocation to fall, partially due to currency weakness (we forecast USD/JPY at 1.28 by 4Q15), but also due to the extremely low JGB yields that are likely to continue for years to come. Together these factors should encourage FX reserve managers to shift into higher yielding assets.
The CHF allocation has also been extremely stable, printing 0.3% for eight consecutive quarters. Further, and similar to the JPY, reserve managers have been actively swimming against the tide (table 3). For example, in response to Q4’s 3.2% currency depreciation, reserve managers actively increased their holdings so much that the CHF actually experienced a net gain in exposure during the quarter.
However, net of currency declines, they were only moderate buyers of GBP, CAD and AUD
The GBP allocation held steady at 3.8% and has remained in a tight 3.8 to 4.0% band since 2012 (table 2). This suggests FX reserve managers have a target allocation in mind for the GBP. To illustrate, table 3 demonstrates that, when faced with the 3.7% depreciation in the GBP in Q4 of 2014, reserve managers actively increased their exposure so that the net decline was only 2.9%. They reacted similarly in Q3, when the GBP depreciated by 5.3%, but reserve managers bought actively so that their net exposure only declined by 2.7%, or roughly half the fall in the currency. However, with the next COFER release we do expect a break below the currency’s post-2012 range, as the GBP has depreciated by over 4% during 1Q15.
Allocations to the CAD and AUD have only been reported for nine quarters and still represent a relatively small proportion of total allocated reserves (1.9% and 1.8%, respectively). In Q4 of 2014 the CAD depreciated by 3.5%, but reserve managers actively bought a moderate amount so their CAD exposure declined by a less extreme 2.8%. Similarly, the AUD weakened by 6.7% in Q4, but exposure to AUD assets only fell by 5.5%. In the next COFER release both currencies are likely to see somewhat smaller allocations, reflecting the sizeable currency depreciations they have both experienced. However, over the medium-term we expect allocations to both CAD and AUD assets to rise, as FX reserve managers diversify away from the USD and EUR. Such a trend should provide a nice tailwind for the two commodity currencies over coming years.
In sum, table 3 demonstrates that, net of currency effects, reserve managers were buyers of all currencies except the USD. Reserve managers were swimming against the strong USD tide, concerned that FX movements were driving the non-USD allocations below their targets. This theme is likely to be equally prominent in the next COFER release.
Table 3: Change in USD value of FX reserves managed in each of the seven currencies, as well as % change in the underlying currency vs. USD over the last four quarters
For example, in 4Q2014 the EUR depreciated by 3.6%, while the value of FX reserves in EUR assets decreased by 3.3%. This implies that, net of currency effects, reserve managers increased their EUR exposure by a moderate 0.4ppts.
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Source: IMF, J.P. Morgan
Our expectations for trends over the longer term are informed by a May 2013 report published by the IMF, “Survey of Reserve Managers: Lessons from the Crisis.” The report presented details from a survey of FX reserve managers (67 countries responded). Their results emphasized that 56% of respondents were considering adjusting the currency composition of their reserves, with 74% of those contemplating a shift to G10 currencies other than the G4 (with highest interest expressed in the AUD and CAD). Overall, FX reserve managers appear to hold quite poorly diversified portfolios, with over 85% of their assets invested in just two currencies.
FX reserve growth has slowed, reflecting the strong USD as well as EM stress
Table 4 shows total FX reserves as well as amounts for the eighteen countries with the largest holdings (note that this table is not based on the IMF’s COFER data). The key takeaway from the table is that the USD value of FX reserves has slowed markedly over the last year. This trend is especially noticeable since July 2014 and coincides with the 15% appreciation in the USD during that time period. A second key driver of slower reserve accumulation has been the level of stress affecting several emerging markets.
The value of total FX reserves is down 0.6% over the last year, with the largest percentage declines experienced by Russia and Malaysia (falling by 29.2% and 15.5%, respectively). Further, the three largest reserve managers have all experienced yoy declines. Among large managers, the key exceptions to this trend include Switzerland, Hong Kong and India, all of whom have been quite active in currency markets.
However, the 1-year decline is a bit deceiving, as FX reserves actually rose by 2.5% during the first seven months of 2014, but have declined by 3.2% since then. One key reason for the decline is the strong USD. To illustrate the logic, imagine that 35% of reserves were invested in non-USD assets and that they declined in USD terms by 10% (say, assuming a 5% local currency return to partially offset the USD’s 15% appreciation). In such a scenario we would expect the USD value of reserves to fall by 3.5%, quite close to the 3.2% that actually transpired.
Table 4: The growth of FX reserves has slowed dramatically
Top FX reserve countries, with China leading the pack. It accounts for 33.0% of the global total and its FX reserves have grown, on average, by 19.3% per year over the last decade (but shrunk by 4.0% since mid-2014).
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Source: J.P. Morgan, Bloomberg
Note: Most recent observation is from January to March 2015 for most countries.
Further, a strong USD is likely a key part of the explanation for the only other time there was a major decline in FX reserves over the last fifteen years. Specifically, reserve assets declined by 5.3% from August 2008 to March 2009, a period during which the USD appreciated by just over 15%. However, while a stronger greenback was an important part of the narrative, it certainly wasn’t the entire story. As Eswar Prasad emphasizes in “The Dollar Trap,” the declines were particularly large for countries such as Russia (37%), Malaysia (30%), India (22%), Mexico (19%), Indonesia (17%) and Turkey (16%). [See Table A-4, FX Reserves Evaporate during the Crisis in “The Dollar Trap: How the USD tightened its grip on global finance.”] He quite persuasively argues that, in many cases, reserves were drawn down to buffer volatile capital flows during the post-Lehman crisis period.
Finally, it is worth noting that the USD link is not just a recent phenomenon or one that is only observed during periods of crisis. For example, over the last fifteen years there has been a 75% correlation between the value of the USD and total FX reserve assets. In fact, over the medium-term, this relationship is much more important than that between reserve assets and various proxies for emerging market stress. The only explanatory variable that appears to be more robust is a remarkably simple and plausible one, nominal Chinese GDP.
The RMB as the next global reserve currency?
Numerous commentators have argued that within a decade the RMB will become one of the top three global reserve currencies. For example, last year the Asia Development Bank Institute argued that the “share of the renminbi in global reserves could reach 12%,” but cautioned that it could “take a relatively long period before it plays the role of a global reserve currency.” SWIFT concurs and describes the path of RMB internationalization as occurring in three phases – first use for trade finance, then for investment, and in the longer term as a reserve currency.
China has certainly made impressive progress in the first two phases of currency internationalization. According to SWIFT, in January 2013 the RMB ranked 13th in terms of usage in world payments. However, by December 2014 it had climbed to 5th, behind only the G4 currencies. It slipped a bit last month (due to February’s New Year’s festivities), but should continue rising over coming quarters.
One step on the path to global reserve status could include modifying the SDR basket to include the RMB. The SDR was first established in 1969 and currently consists of only four currencies (USD at 41.9%, EUR with 37.4%, GBP 11.3% and JPY at 9.4%). Beijing has been pursuing this goal since 2009 (with Governor Zhou’s speech, “Reform the International Monetary System”) and appears to finally be gaining some traction. Earlier this month Governor Zhou again called for the IMF to add the yuan to its SDR basket.
While the IMF initially demonstrated reluctance, lately it has seemed more open to the idea. The previous review was held in November 2010, with the SDR weights revised based upon two criteria: the value of each country’s exports and the value of FX reserves denominated in each currency. The IMF Executive Board has discussed possible options for broadening the SDR basket and this issue could be on the table during the April 17-19 meetings in D.C. Regardless, there will be an informal briefing in May, followed by the IMF’s Executive Board conducting its twice-a-decade review in October.
Additionally, FX reserve managers from eight different countries have stated their intent to invest in RMB assets, with three having confirmed that such investment has already taken place. This process will almost certainly accelerate as China’s financial markets develop and the capital account is liberalized. All this suggests the RMB is highly likely to become a major global reserve currency over coming years and appears well placed to then assume a prominent ranking in tables 1 and 2 above.

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