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Central Bankers Shy Away from Holding Euros

Date: Wednesday, June 2, 2010
Author: Bloomberg

Wall Street’s foreign-exchange strategists say central bankers are showing growing reluctance toward holding euros as Europe’s debt crisis undermines confidence in the region’s single currency.

The euro weakened 2.4 percent against the dollar last week even after China’s State Administration of Foreign Exchange, which manages the country’s $2.4 trillion of reserves, denied speculation that it was diversifying away from European bonds. The 20 percent depreciation from last year’s peak in November has demonstrated the limits of the euro as a reserve currency to rival the dollar as well as the European Central Bank’s ability to defend its legal tender.

A net 105 billion euros ($129 billion) flowed out of the region’s fixed-income markets on an annualized basis in the first three months of the year, signaling a “broad shift” in appetite for euro-denominated assets, according to Nomura Holdings Inc. The region attracted a net 225 billion euros from foreign debt investors in 2009.

“It’s clearly the case that there’s been an element of foreign central banks slowing down their euro purchases,” said Jens Nordvig, a managing director for foreign-exchange research at Nomura in New York. “The institutional framework is being questioned, the credibility of the ECB is being questioned, and all that uncertainty is really fueling an asset allocation shift away from the euro zone.”

Switch in Strategy

Institutional investors, including some central banks, have become net buyers of U.S. bonds since Europe’s debt crisis began, based on Bank of New York Mellon Corp. iFlow data, which monitors total assets of about $30 trillion. As of May 20, when the euro traded $1.2487, cumulative flows into Treasuries totaled four times the average amount over the previous year. The last time the euro traded below $1.25 in March 2009, investors were sellers of U.S. bonds at 10 times the previous year’s average, and put money into euro-denominated assets and other currencies.

“There’s a growing realization that the outlook for the currency is bleak,” said Samarjit Shankar, a managing director for the foreign exchange group in Boston at BNY Mellon. “There is evidence that central bankers and reserve managers are trying to diversify away from euro.”

Relative Growth Outlook

European Union leaders unveiled an almost $1 trillion loan package last month to halt the slide in the euro and local bonds that threatened to shatter the currency union after Greece’s budget deficit expanded to almost 14 percent of gross domestic product, exceeding the EU’s 3 percent limit without penalty. Last week, Spain lost its AAA credit grade at Fitch Ratings as the nation struggles to cut the euro region’s third-largest budget deficit as percentage of GDP.

“Europe is likely to go through a weak period” because governments will implement “more austerity measures in the face of a weak economy” Nobel-prize winning economist Joseph Stiglitz said in an interview in Stockholm today.

The euro-zone economy may expand 1.1 percent this year, compared with 3.2 percent for the U.S., according to the median estimate of analysts in Bloomberg News surveys.

The euro fell as much as 1.6 percent against the dollar to $1.2111 today, the lowest since April 14, 2006. It depreciated as much as 2.3 percent to 109.77 yen. The Financial Times reported last week without saying where it got the information that Chinese officials have been meeting with foreign bankers to review holdings of euro-zone debt.

‘Structural Debt Problems’

The euro is dropping the fastest since the bankruptcy of Lehman Brothers Holdings Inc. in September 2008 triggered a funding shortage that pushed it and 14 other major currencies down against the dollar. Back then, it fell 21 percent by Dec. 1, 2008, the biggest slump in the euro’s 11-year history.

That decline set the stage for a rally as the euro recovered amid concern that the U.S. would struggle with a growing budget deficit.

“Both the dollar and the euro have structural debt problems but at least Europe is doing something about it,” said David Bloom, global head of currency strategy at HSBC Holdings Plc in London. “The pendulum will swing against the dollar later this year as people realize that the U.S. has even bigger problems than the E.U.”

HSBC predicts the euro will end the year at $1.35 as the U.S. mid-term elections in November shift attention to the nation’s inability to reduce a deficit projected to reach $1.5 trillion this year.

Volcker’s Prediction

The latest data from the International Monetary Fund shows that the euro made up 27.4 percent of global currency reserves at the end of 2009. While that was down from 27.8 percent in September, it was up from 26.4 percent a year earlier.

“Central banks will watch the situation in the euro zone closely, but they know that if they were to sell a large amount of euros now, the market will move sharply,” said Mansoor Mohi- uddin, the global head of foreign-exchange strategy at UBS AG in Singapore. “What will happen instead is that they slow down their purchases of the euro, and that’s enough to weaken the currency.”

While the euro became a rival to the dollar after its inception in 1999, the debt contagion that began in Greece is driving investors away. Former Federal Reserve Chairman Paul Volcker said May 13 in London that he’s concerned the euro area may break up after the rescue package failed to stem the currency’s decline.

“You have the great problem of a potential disintegration of the euro,” Volcker, 82, said in a speech. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” with the creation of the euro has “so far not been rewarded in some countries,” he said.

Cutting Estimates

China’s State Administration of Foreign Exchange, which manages $2.4 trillion of reserves, holds about $630 billion of euro-area bonds and has expressed concern about its exposure to Greece, Ireland, Italy, Portugal and Spain, the Financial Times said. The agency said later in a statement that “the media report that SAFE is reviewing its euro holdings was groundless,” without specifying the media to which it was referring.

Strategists aren’t keeping up with the declines. The median of 48 forecasts is for it to end the year at $1.22. In February they predicted $1.43.

The number of wagers by hedge funds and other large speculators on a decline in the euro stood at 106,736 contracts more than those anticipating a gain on May 25, near the record 113,890 on May 11, according to data from the Washington-based Commodity Futures Trading Commission. As recently as December, bullish contracts exceed bearish ones by 22,151.

Kokusai’s Choice

While a weaker euro makes European exports more competitive, it may damp the appeal of financial assets. A foreign investor in German bunds would have lost 8.7 percent this year after exchanging euros for dollars, Bank of America Merrill Lynch indexes show.

Kokusai Global Sovereign Open Fund, Asia’s biggest bond fund, cut its euro-denominated holdings to 30 percent of assets, the least since 1998, from 42 percent at the beginning of the year, Masataka Horii, one of four investors for the funds, said in a May 10 interview in Tokyo. Kokusai Global boosted dollar bonds to 22.1 percent from 18.6 percent.

Demand for dollars was evident in a monthly report by the Treasury Department released May 17 that showed net purchases of U.S. financial assets soared to a record in March as investors from China to the U.K. purchased the most Treasuries since November. Net buying of equities, bonds and other assets totaled $140.5 billion, up from $47.1 billion in February.

Risk Reversals

The premium to buy options giving investors the right to sell the euro rose to the most since before 2003 relative to those that allow for purchases. The currency’s three-month options risk-reversal rate fell to minus 3.35 percent on May 26, from minus 1.25 percent in December, signaling a relative increase in demand for puts, which grant traders the right to sell the euro versus the dollar.

“The move lower in the euro is not just speculation,” said Lee Hardman, a currency strategist at Bank of Tokyo Mitsubishi UFJ Ltd. in London. “There has been an asset allocation away from euro. The problem is deeply rooted and fundamental in terms of unsustainable fiscal deficits.”