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10 Aug 2018


Impact: Negative (Exchange Rate/ Rupee Value)

Brief: The US Federal Reserve’s Forex Reserves have been declining since the year 2012, which was the time when the impact of the Taper Tantrums started to resonate. As per our analysis, the reason behind the fall of the American forex is less to do with intervention and more to do with appreciating Dollar. We find that the negative correlation between rising Fed Fund Rate and Fed Foreign Reserves is almost (-) 60%. Therefore, recent fall in India’s forex is not influenced by volatility driven interventions alone.

While the consensus regarding the fall of Foreign Exchange reserves across major central banks has been blamed on interventions, we believe that there is something else at play. It can be referred from the chart below, Forex reserves are held in several currencies, including the Euro, Japanese Yen and the US Dollar. Over the past few years, it has been detected that most Forex reserves have been shedding value; global volatility was cited as the prominent reason due to higher central bank interventions in the open market. The American Federal Reserve’s declining Forex Reserve is a case in point here.

We observe that the most serious declines in the American reserves happened in the calendar year 2012, when the US Fed started to raise concerns regarding interest rates. The central bank was particularly worried about the rapidly improving health of the American economy and resulted inflationary situation. Even though the first rate hikes did not come before the 2015-16 period, there were significant concerns pertaining to normalization. This diabolical period caused serious volatility in the world’s financial markets and came to be known as ‘Taper Tantrums’. Ever since, the US reserves themselves have been recording an average annual decline of nearly 3%.

Most analysts associate this decline with Fed’s intervention to stabilize a highly volatile US Dollar. However, one look at the components of the Foreign Currency Assets (FCA) reveals that currency holdings of Euro and Japanese Yen have been declining in almost equivalent amount. This is surprising as interventions toward Dollar stabilization should have accompanied an appreciation of other major global currencies. Since the Fed’s (and other Central Banks) FCA currencies are generally denominated in the US Dollar (for computing purposes), the declining value of these currencies versus the Dollar is being recorded in the FCA calculations.

Therefore, the declining value of the portfolio comprising these other currencies is visible. When the interest normalization cycle finally started, the decline accelerated a bit before momentarily pausing. This was because of increased yield chasing inflows to emerging markets depreciated the Dollar for a while before the tide reversed. The negative correlation between rising Fed Fund Rate and Fed Foreign Reserves is almost 60%. The declining Chinese Forex and explanation emanating from the Chinese Peoples Bank’s State Administration of Foreign Exchange (SAFE) resonates well with this hypothesis. This has significant ramifications for India’s Forex Reserves as well – since it is party to similar calculations. Recent fall in India’s reserves is therefore not influenced by volatility driven interventions alone.

Euro (Value in bn $)Yen (Value in bn $)TotalUS Forex (in bn $)Fed Fund Rate
Dec. 201726.4116.5742.98122.181.30
Mar. 201826.8617.6144.47125.38
July. 201825.4016.8642.26120.501.82

Source: US Department of Treasury