In this note, BNY Mellon Chief Global Markets Strategist Jack Malvey and his team explain why they believe the growth rate of foreign exchange reserves has peaked and what that may mean for investors.
The tremendous accumulation of foreign exchange reserves by world central banks has been one of the great financial market narratives of the early 21st century. Between 2003 and 2007, foreign exchange reserves more than doubled from $2.8 trillion to $6.1 trillion. Another almost-doubling occurred between 2007 and 2014 ($11.8 trillion).
Indeed, this data somewhat understates the prodigious reserve acquisitions. Some of the reserves were peeled away from central banks and dispatched to often newly created sovereign wealth funds.
Like virtually all trends in financial markets, the pace of foreign exchange reserve buildups has shifted, meaningfully decelerating and even reversing for some institutions. As shown in Figure 1, world foreign exchange growth plummeted to 1.91% in 2014 from a 5-year velocity of 9.05% and a 10-year tide of 12.81%. Given the substantive appreciation in the U.S. dollar, sluggish global growth and particularly the fall in energy prices, this statistical observation should not entirely surprise. Over 2014, oil-producing nations experienced a 7.8% decline in their foreign exchange reserves. Concurrently, Asian export-dependent economies, often directly or indirectly pegged to the strengthening U.S. dollar, managed only a 0.76% augmentation of their foreign exchange reserves in 2014.
|Prior 11-yrs||Prior 10-yrs||Prior 5-yrs||Prior 1-yr|
As with every financial market parameter, numerous assumptions govern long-term predictions of foreign exchange reserve growth. For example, oil might regain its lofty $100+ per barrel valuation. World output expansion may eventually advance at a quicker clip, led by the U.S., and by definition in this largely floating-exchange rate era, future perturbations in exchange rates could well favor export-reliant nations.
Given this forecasting challenge, a multi-scenario table provides better guidance than a singular point forecast. Accordingly, Figure 1 includes a table of projected foreign exchange reserves to 2025 under four growth scenarios ranging from -2% to 7%. In our view, the most reasonable assumptions point to a growth rate of between 2% and 5%. The extraordinarily low yields available in the world bond market also influence our opinion. On February 5, 2015, the average yield on the Barclays Global Aggregate Index was only 1.45%. Given that many central banks invest mainly at the short and intermediate part of yield curves, as well as the negative yields out to intermediates in many parts of the European debt theater, the coupon flow from existing bond holdings will not provide much reserve growth lift.
Altogether, this analysis implies an appreciation in foreign exchange reserves from $11.8 trillion at the end of 2014 to between $14.62 trillion (2% growth) and $20.11 trillion (5% growth) by the end of 2025.
Next, we calculated the proportion of central bank foreign exchange reserves to the global financial asset choice set under various scenarios in 2025 as specified in Figure 3. This calculation hinged on first deriving the size of the global financial asset choice set as shown in Figure 2.
As depicted in Figure 3, central-bank reserves would constitute only 0.82% of the world financial system if the overall market grows by 10% per annum on average while foreign exchange reserves contract at a 2% rate. At the other end of the spectrum, foreign exchange reserves could represent about 4.42% of financial system assets should reserves advance by 7% per annum accompanied by 3% growth of the total financial asset choice set.
Nonetheless, foreign exchange reserves will continue to represent a mighty pool of capital, tasked with the unique purpose of stabilizing local and global financial markets.
BNY Mellon Investment Management
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The conclusions from this analysis:
|Global Financial Asset Choice Set Growth (cagr, %) to 2025|
|Global Foreign Exchange Reserves Growth (cagr, %) to 2025||3%||5%||7%||10%|
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Chief Global Markets Strategist, BNY Mellon Investment Management