The Daily Update - Emerging market foreign exchange reserves in China and Turkey

Back in April we wrote about the inflated concerns over the decline of Chinese foreign exchange reserves. Since then China’s reserves seem to have stabilised around the USD 3.2tn level. As we argued, this should be more than sufficient to counter capital flight and attacks on the currency due to China’s overall creditor position, relatively low levels of liability dollarization, diversified export economy and exaggerated level of M2 money supply and liquidity. Given such considerations the simplistic IMF formula for estimating the adequacy of emerging country reserves should be adjusted substantially lower for China. Combining such an adjustment with the stabilising trend of the last 6 months should provide confidence that Chinese officials have the financial and policy resources to achieve their objectives as they move towards becoming an official global IMF reserve currency in 3 months’ time and beyond.

Turkey, in the midst of political and civil unrest, is an entirely different scenario. It has long been at the apogee of vulnerable emerging economies with a large current account deficit and excessive levels of vulnerable short term external liabilities. Yet somehow they have managed to roll over these debts in previous crises, but investors should not assume that markets will always be this lenient. Public debt figures do not look particularly alarming at around 30% of GDP. But this is where taking a broader Net Foreign Asset (NFA) perspective helps highlight domestic risks that emanate from different systemic issues. From this perspective, Turkey’s Net Foreign Liabilities are approaching 100% of GDP, a critical level where historically many countries have subsequently defaulted and maintaining interest repayments can quickly become unmanageable with even the slightest change of market sentiment.

For Turkey, the excessive foreign currency risk lies in the hands of its banks (and corporations) who have borrowed abroad and been lending in lira domestically. An important aspect of understanding Turkey’s inner financial workings and reserves is that the Turkish central bank allows bank capital requirements to be met with gold and dollar reserves. This helps facilitate the mismatch in bank’s borrowing and lending (alongside some off balance sheet hedging) but means that some of Turkey’s (already unsubstantial) USD ~100bn of FX reserves are little more than borrowed from the banks. A liquidity crisis or run on foreign currency deposits could see the banks drawing down on these dollar reserves just as the central bank may want them to help stabilise the currency. The risks of such a mechanism make the currency much more vulnerable to sharp depreciations in such scenarios - and such scenarios seem ever more likely when domestic unrest feeds market fears. We do not currently invest in Turkey or the lira but generally in countries that are net foreign creditors that still offer relatively high return.

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