Fitch: 'Quantitative Tightening' An EM Issue, Not A DM Risk

The decline in global foreign exchange reserves thus far in 2015 may add to macroeconomic pressures on emerging markets (EM) but it does not directly risk a "quantitative tightening" effect on developed markets (DM), says Fitch Ratings.

EM sovereign foreign exchange reserves fell by USD189bn between end-December 2014 and end-June 2015, according to IMF and Chinese data compiled by Fitch. The biggest declines were in China (down USD149bn) and Saudi Arabia (down USD60bn), partly offset by increases in other countries, led by India (up USD35bn). More timely data from some countries, including notably China suggest the drain continued in July and August. Fitch estimates about USD100bn of the decline to June may have been caused by valuation effects, based on the 4.3% trade-weighted appreciation of the US dollar in the first half of the year. Nonetheless, some of the decline will reflect genuine draw-down by EM central banks.

Large EM central banks have been net sellers of US Treasurys in recent months. However, there is an important fundamental difference between transactions in US Treasurys by the Federal Reserve versus the central banks of other countries. When central banks other than the Fed sell the dollars they have obtained from selling US Treasurys, those dollars remain circulating within the financial system - and could even end up reinvested in US Treasurys.

In contrast, when the Fed sells Treasurys from its balance sheet and obtains US dollars, those dollars are effectively removed from the financial system as they are liabilities of the Fed. Sales of securities by the Fed without offsetting transactions would constitute genuine dollar "quantitative tightening".

EM reserves depletion may exert an indirect effect on US rates if the dollars shift to institutions with lower allocations to US Treasurys than the EM central banks that originally held them. Term and risk premiums could decrease if the system as a whole rebalances its portfolio to riskier assets out of Treasurys. However, it is uncertain as to whether this effect would be significant and it seems unlikely that it would offset the broader de-risking that would likely be taking place under the scenario of a drain in EM reserves.

Sales of dollars in exchange for local currency by EM central banks may nonetheless lead to quantitative tightening in emerging markets themselves. Sale of dollars for local currency, without offsetting transactions, leads to the destruction of local currency base money, thereby keeping the central bank's assets and liabilities equal at a shrinking size. Other things equal, this would tighten domestic monetary conditions and put upward pressure on domestic interest rates.

EM central banks have the option to replace the lost liquidity by other means such as repo or outright purchases of securities. However, this risks fuelling demand for dollars until a sharp adjustment of the exchange rate occurs once foreign reserves are finally exhausted - the classic EM balance of payments crisis. It is worth noting that almost all EMs are well away from this danger point, even after recent reserve depletion and a global systemic EM crisis on the pattern as last occurred in 1994-1997 is not Fitch's base case.