First the Dow went through 20,000, then it broke above 21,000. After that, the inevitable 'Dow to 35,000' articles began surfacing and investors were dancing in the streets and everything was rosy. Concerns about a Donald Trump presidency were replaced with surging business confidence as his pro-business policy got the two thumbs up.
However, growing foreign currency reserves held by emerging market countries suggest the good times are limited to developed nations. It seems that emerging market economies are preparing for a possible period of uncertainty. (See also: How to Avoid Emerging Markets Volatility)
In February, China's foreign currency reserves unexpectedly rose for the first time in eight months, heading back above the $3 trillion mark, the People's Bank of China (PBOC) said on Tuesday. China joins a growing number of emerging market central banks that are increasing reserves to protect against periods of uncertainty. The Wall Street Journal reported that two-thirds of the biggest 30 emerging market countries increased foreign-currency reserves in 2016.
Some of the reserve accumulation is the result of growing inflows into emerging markets as developed countries continue to export at a faster pace than ever. However, trade flows do not tell the whole story.
Why Hold FX Reserves?
Countries increase FX reserves by buying foreign currencies and selling their own currency. Reserve accumulation is used as a tool to stem the appreciation of one's own currency, which hurts the export sector. And in a period of rapid appreciation, these reserves help reduce volatility.
Emerging market countries, which are more susceptible to shocks, hold reserves as a tool to stem rapid capital outflows. The latter phenomenon has become prevalent in China, as mainland investors seek to ship money into foreign assets. Additionally, countries will hold reserves to provide comfort for investors.
Risk of Increasing Reserves
While increasing foreign reserves will provide comfort for investors, officials are worried that growing reserves are creating imbalances that will distort trade policies. "At the same time, we need to recognize that a central element of the safety net is reserve accumulation. This has served an important purpose - especially in this region since the Asian Crisis," Mitsuhiro Furusawa, IMF Deputy Managing Director said at a conference on Wednesday. "But reserve accumulation can be a costly defense. It leads to inefficient resource allocation, hinders external adjustment, and can contribute to looser policies on the part of reserve issuers."
The U.S. Dollar is the largest foreign reserve held by emerging markets, so any volatility in the dollar and USD-denominated assets can lead to potential shocks. As the Fed begins what could be a sustained period of tightening, debt held by foreign countries could become burdensome. (See also: Playing a Surge in Russian Bonds)
The Bottom Line
Developed countries have seen a recent pick up in inflation and growth. However, the growing reserve accumulation among emerging market countries suggest they are bracing for a period of tougher times. In Europe, peripheral countries are increasing reserves as they prepare for what could be a turbulent 2017 as elections set to test the stability of the European Union, and in the Middle East, countries are still recovering from the 2015 oil shock, which drained reserves to record lows, leading to accumulation in 2016.