FOREIGN RESERVES SLIP IN EMERGING MARKETS, RAISING RISKS / THE WALL STREET JOURNAL

Foreign Reserves Slip in Emerging Markets, Raising Risks

While still relatively robust, diminishing currency hoards reduce capacity to ride out crises

By Carolyn Cui

Updated June 23, 2015 9:40 p.m. ET

A board displays currency-exchange rates in March in Istanbul, where the Turkish lira recently hit a record low against the dollar. Photo: OSMAN ORSAL/REUTERS


Central banks in emerging markets are running down their foreign-currency reserves at the fastest pace since the financial crisis, reducing some countries’ capacity to weather potential shocks, such as a rate increase in the U.S.

Total foreign-exchange reserves in emerging countries are estimated to have dropped $222 billion to $7.5 trillion during the first quarter, according to a Wall Street Journal analysis of International Monetary Fund data. The 3% decline in reserves would be the biggest percentage loss for a quarter since the first quarter of 2009.

Despite the drop, total foreign reserves still are hovering around record highs for emerging countries, giving observers confidence that they are, overall, in a relatively strong position to withstand external shocks in periods of stress. Some countries, such as Russia, have been rebuilding their reserves after significant declines. Total foreign reserves are able to cover about 11 months of import needs for these countries, according to IMF data, while a rule of thumb for adequacy is six months.

“We are not that worried about some of the drop in foreign-exchange reserves,” said Joyce Chang, global head of research at J.P. Morgan JPM -1.05 % Chase & Co., noting that the drop has been limited to a handful of countries that hold the largest amounts of reserves.

Still, the risk is rising in a number of countries that are grappling with sluggish growth, lower reserves and weaker currencies. The concern is that when the U.S. Federal Reserve raises rates—probably later this year—the subsequent increase in yields will lure cash to the U.S. that had been invested in emerging countries, where rates are high already. For those countries whose reserves are too meager to absorb the shocks, their currencies—many of which already have fallen in value—could face more downward pressure.

                   
 

Turkey, South Africa, Malaysia and Indonesia are among vulnerable countries whose reserves have fallen below their short-term external financing needs, according to the Institute of International Finance. Early this month, the Turkish lira hit a record low against the dollar after its ruling party failed to secure a majority in elections, while Malaysia’s ringgit, South Africa’s rand and the Indonesian rupiah all sank to multiyear lows.

“It’s a source of concern,” said Andy Keirle, portfolio manager of the T. Rowe Price Emerging Markets Local Currency Bond Fund. “We’re nervous about South Africa and Turkey, as there have not been a lot of policy moves to reduce their external imbalances.”

The concern is evident in investment flows. This year, foreign investors have yanked $23.9 billion out of emerging-market equities, according to J.P. Morgan. Meanwhile, nearly $200 million has been withdrawn from emerging-market local-currency bonds. Equities and local debt are more susceptible to currency moves.

Foreign reserves are regarded as a gauge of a country’s ability to withstand currency swings. Many emerging countries have allowed their currencies to float since the 1990s Asian financial crisis, but their central banks still engage in periodic interventions to prevent excessive volatility in exchange rates. During the first quarter, volatility in the world’s currency market reached a fever pitch, leading many to spend billions of reserve dollars to defend their currencies.

The IMF is scheduled to release its official count on foreign reserves June 30 through a quarterly report on the Currency Composition of Official Foreign Exchange Reserves, known as the Cofer report. Previous Cofer reports showed reserves already had dwindled for two quarters, to $7.7 trillion by the end of 2014; the latest decline would bring the total reserve losses to $542 billion, a 6.7% drop from mid-2014.

Part of the recent reserve decline was due to a broad-based dollar rally.

A surging dollar leads to lower values for reserves held by emerging countries in euro, yen and other hard currencies. Morgan Stanley Investment Management estimated that about 40% of the reserve drop was due to currency valuation changes.

But Olivier Desbarres, an independent emerging-market strategist, estimated the entirety of this fall was due to currency fluctuations. Estimates vary widely, because China doesn’t disclose its reserve currency compositions.

The decline represents a reversal from a decadeslong trend of rapid reserve accumulation in developing countries amid strong capital inflows and trade surpluses. According to the IMF, total emerging-market foreign reserves had risen from $610.6 billion in 1999 to peak at $8.1 trillion last June.

The buildup lately has reversed, as these countries face slower global trade and weaker growth. More recently, a dollar surge, falling commodity prices and some country-specific problems have come into play, exacerbating the drain in reserves.

Nearly half of the decline—$113 billion—was in China, which faces shrinking trade surpluses and growing capital outflows. Its central bank was also seen to have propped up the value of its currency by selling dollars, driving its foreign reserves down to $3.7 trillion.

Russia’s reserves also fell last quarter, as the central bank attempted to bolster its currency amid lower oil prices and sanctions. But Moscow managed to arrest the reserve’s decline, and it resumed purchasing dollars recently. Saudi Arabia, Nigeria and Malaysia also suffered steep reserve losses due to reduced revenues from commodity exports.

The reserve drain is “a confirmation of all the potential stresses that are facing emerging markets right now and probably going forward,” said James McCormack, global head of sovereign ratings at Fitch Ratings.

The IMF publishes the total official reserve assets in its International Financial Statistics data set, which include countries’ reserves held in foreign currencies, gold, Special Drawing Rights and positions with the IMF. (The SDR is an international reserve asset created by the IMF to supplement its financing efforts.)

“What happened over the past year was very striking,” said Charles Collyns, chief economist at the Institute of International Finance. “It indicates that a number of emerging countries have greater external vulnerability…in some cases raising concerns about the possibility of an external crisis.”
 
Venezuela is making every effort to avoid such a crisis. Its reserves fell to a 12-year low of $17.9 billion in May as the economy struggled. The government has been desperate to shore up its reserves by borrowing from China and selling some assets. Yet its currency, the bolivar, has collapsed in the unofficial market. Officially, the bolivar is pegged to the dollar at a 6.3 fixed rate, but lately a dollar has been buying about 465.

“The environment has turned less supportive for flows into emerging markets,” said Jens Nystedt, a portfolio manager of emerging-market debt at Morgan Stanley Investment Management. “Those countries that are adjusting properly…have a lot more degrees of freedom to deal with any shock.”

—James Ramage contributed to this article.