Asset management

14 May 2012

Economist Insights Muck and brass

Despite last weeks tensions related to the political uncertainty in Greece, the euro (EUR) has hardly weakened. Diversification of foreign exchange reserves by emerging market central banks and domestic banks selling foreign asset could be an explanation. The relative strength of the EUR could, however, be related to the Core countries being a natural safe haven against a political accident in Greece. In other words, if you want to hedge against a Greek exit you do not really need to move your assets out of Europe but just to move them to the Core countries. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

There is a phrase from northern England that says: where theres muck, theres brass. Even in garbage, the saying tells us, you can find value. Apply this idea to the Eurozone, and it explains a lot about why the single currency has maintained its value throughout the crisis. For nervous foreign investors, the EUR is a currency that has both muck and brass: weak periphery assets and strong core assets. With the uncertainty around the Greek election, the muck has started to smell worse than usual. The risk has increased of a self-defeating political mistake that sees Greece exit from the single currency. Despite the greater uncertainty and increased risk, the EUR only depreciated by just over 1% against the US dollar (USD) last week. This stability is not because Greece is not risky, it is because Germany and the core are safe havens. In a typical currency crisis, domestic holders of currency often attempt to flee overseas to safe havens abroad, pushing the currency down further. Within the Eurozone, those safe havens are available within the same currency just send your money to one of the core countries. This has no direct effect on the currency. Foreign holders of the EUR can take the same approach. When an investor buys EUR, they are typically buying very short-dated assets in the country. Instead of buying short-dated EUR assets distributed across all the Eurozone countries, an investor can choose to buy short-dated EUR assets only from the core countries. This has the added advantage that in the event of a break-up of the single currency, the currency or currencies of the core countries would be likely to appreciate sharply. Paradoxically, this may

even encourage foreign investors who are pessimistic about the future of the single currency to buy the single currency (as long as the exposure is in the core). In short, within the single currency the upside to the brass (core assets) counterbalances the downside to the muck (periphery assets). This leaves the value of the EUR to be determined by more traditional fundamental factors. First on the list is the relative stance of monetary policy. Despite the problems the Eurozone faces, the odds of the Federal Reserve adopting further loosening of monetary policy remain higher than the European Central Bank doing the same. All else being equal, this should make the USD weaker than the EUR.
Chart 1: Back to basics Model estimate of EUR/USD based on interest rate differentials, relative equity performance, emerging market spreads (as a risk proxy) and the oil price

1.7 1.6 1.5 1.4 1.3 1.2 1.1 2007 2008 Actual EUR/USD

2009

2010 Model estimate

2011

2012

Source: Bloomberg, UBS Global Asset Management

A model of the EUR/USD exchange rate based on the differential between interest rates (as well as relative performance of equities, global risk appetite and market performance) actually suggests that the value of the EUR should be higher (see Chart 1). The model estimate may be too high because it is underestimating the impact of the ECBs long-term refinancing operations, or it could be that the uncertainty in Greece combined with the banking issues in Spain is actually having a negative effect on the currency that is not captured by the model. There are alternative explanations for the resilience of the EUR. One explanation could be ongoing diversification of foreign exchange reserves by emerging market central banks. Indeed, the EUR has tended to appreciate against the USD during periods when the Peoples Bank of China is accumulating more foreign reserves (see Chart 2). Unfortunately, they and many other central banks do not release the actual breakdown of their holdings, so this is conjecture at best. All this begs the question of why emerging market central banks want to hold more EUR when the Eurozone is facing so many problems. It is likely that they also understand the concept of buying the brass rather than the muck. It may also reflect a suspicion that the US is far more likely than Europe to inflate its way out of its debt problems, a strategy that would be very bad for the value of the USD. If either of these flows are important, their effect is likely to be temporary.
Chart 2: Brass reserves EUR/USD exchange rate and 3-month change in Chinese official reserves minus gold (in millions of SDRs)

A third explanation may be the behaviour of the banking sector. Having come under a lot of stress, and preparing for their Basel III capital requirements, many Eurozone banks have been cutting back on their exposures to the rest of the world. Selling off subsidiaries or failing to rollover loans would result in quite significant flows into the EUR. However, there is likely to be a countervailing pressure from US banks withdrawing from the European market a trend that was reported in a recent Federal Reserve banking survey. There have also been reports of Japanese insurance companies repatriating funds. All these flows are at best a temporary phenomenon. A last explanation is simply that the Eurozone is broadly in trade balance, while the US still has a large trade deficit. Germanys trade surplus is offset by a trade deficit elsewhere. This makes the US reliant on external funding but the Eurozone overall is not. Dependence on volatile external funding could make the USD more susceptible to sentiment changes among foreign investors. Political and fiscal uncertainty is high in the US as well, so there are plenty of things that can scare foreign investors. A currency exchange rate is always expressed as a pair, and all this works to weaken the US part of the pair. The future of the single currency may look more fragile than ever before, but the mix of strong and weak assets means that investors are effectively hedged against some of that risk. Despite the political uncertainty, there are still plenty of opportunities for investors willing to take bets on the relative path of monetary policy or the pattern of central bank reserve accumulation. Or, to put it another way, where theres muck, theres brass.

160 120

1.7

1.5 80 1.3 40 0 1.1

2008 2009 2010 3m change in EUR reserves (lhs)

2011 EUR/USD (rhs)

2012

Source: IMF, Bloomberg. Note: SDRs are Strategic Drawing Rights, a basket currency of USD, EUR, JPY and GBP used by the IMF.

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