National governments are
routinely active in the forex market, but not for purposes of attempting to
realign or shift the values of the major currencies.
Instead, national governments are
active in the forex market for routine
funding of government operations, making transfer payments, and managing foreign
currency reserves. The first two functions have generally little impact on the
day-to-day forex market, so I won’t bore you with the details. But the last one
has taken on increased prominence in recent years, and all indications are that
it will continue to play a major role in the years ahead.
Currency Reserve Management
Currency reserve management
refers to how national governments
develop and invest their foreign currency reserves. Foreign currency
reserves are accumulated through international trade. Countries with large
trade surpluses will accumulate reserves of foreign currency over time. Trade
surpluses arise when a nation exports more than it imports. Because it is receiving
more foreign currency for its exports than it is spending to buy imports,
foreign currency balances accumulate.
The USD has historically been the
primary currency for international reserve holdings of most countries. International
Monetary Fund (IMF) data from April 2007 showed that the USD accounted for
about 65 percent of global currency reserve holdings, with EUR and JPY as the
next most widely held currencies.
ln recent years, however, the
United States has run up massive trade and current account deficits with the
rest of the world. The flip side has been the accumulation of large trade
surpluses in other countries, most clearly in Asia.
The U.S. deficits essentially
amount to the United States borrowing money from the countries with trade
surpluses, while those other countries buy
lOUs in the form of U.S. Treasury
debt securities.
The problem is one of perception
and also of prudent portfolio management:
- The perception problem stems from the continuing growth of U.S. deļ¬cits, which equates to your continually borrowing money from a bank. At a certain point, no matter how good your credit is, the bank will stop lending you money because you’ve already borrowed so much in the first place. In the case of the United States, no one is sure exactly where that point is, but let’s just say we don’t want to find out.
- The portfolio-management problem arises from the need to diversify assets in the name of prudence. This point has taken on added urgency since the U.S. dollar began to weaken against other major currencies at the start of this decade. Not only had emerging market governments allowed their foreign currency reserves to reach massive levels and kept the proportion of USDs in them very high, but now the U.S. dollar was starting to weaken as well.
The result has been an effort by
many national governments to begin to diversify their reserves away from the
USD and into other major currencies. The euro, the Japanese yen, and, to a
lesser extent, the British pound have been the principal beneficiaries of this
shift. But before you think the sky is falling, the USD remains the primary reserve
currency globally and most reserve diversification efforts are focused on new
reserves being generated.
In terms of daily forex market
trading, national governments (or their operatives) have become regular market
participants over the last few years. Generally speaking, they appear to be
engaging in active currency reserve management, selling USD on rallies, and
buying EUR on weakness. But they’re also not averse to then selling EUR on
subsequent strength and buying USD back on weakness.
Currency reserve management has
taken on a market prominence in recent years that never existed before. Market
talk of central bank buying or selling for reserve management purposes has
become almost a daily occurrence. The impact of this in the market varies, but
it can frequently lead to multiday highs and lows being maintained in the face
of an otherwise compelling trend.
Traders need to closely follow
real-time market commentaries for signs of central bank involvement.
