Hedge with an edge

Cash management, Macro and Markets

The euro moves centre stage

December 2019

Two decades since its launch, the euro’s role in the international financial system is in transition. As usage of the single currency grows for borrowing, inter-bank funding and cross-border carry trades, the eurozone is emerging as the new global provider of liquidity to the international financial system and displacing the dollar, says Deutsche Bank’s Corporate Bank Focus Research team

Unnoticed by many, the euro is increasingly first choice for global borrowing, inter-bank funding and cross-border carry trades, reports Graham Buck. While no-one now wants to hold euro cash as an asset, everyone wants it as a liability. In response, the eurozone is emerging as the new global provider of liquidity to the international financial system, and steadily displacing the dollar.

Analysis of the euro still focuses on its role as an asset, reserve or investment vehicle, but 21 years since its launch far bigger shifts are taking place in the single currency’s status as a global liability currency. Its role in the international financial system is being fundamentally transformed, suggests a report from Deutsche Research, head of FX research, George Saravelos.

He notes the European Central Bank’s adoption of unconventional policies in recent years. The first phase was marked by large European portfolio outflows; this is now followed by a new phase of outflows based on rising euro funding. For the FX market this latest trend has kept the euro subdued and volatility benign during periods of positive risk appetite. However, any future period of risk aversion could see sharp bouts of volatility and euro appreciation. “Europe is becoming the world’s new carry trade,” comments Saravelos.

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George Saravelos

is Deutsche Bank’s Global Head of FX Research

The pendulum swings back

Central to flow dynamics in the euro is the balance of payments. Since late 2017 the euro’s broad basic balance – the sum of the current account, portfolio flows and foreign direct investment (FDI) – has swung to a huge surplus, with nearly US$1 trillion added over two years and all components of the basic balance now positive – a ‘first’ in the euro’s lifetime.

Saravelos says that portfolio flows, triggered by the ECB’s recent aggressive policy of balance sheet expansion and negative interest rates, are key drivers of this change. European investors moved their portfolios to the rest of the world over the period 2014-16, when €1trn euros of European capital shifted into foreign bond markets. Then, as European offshore assets built and growth prospects stabilised, these outflows dried up and moved close to balance. Combined with a 3% of GDP current account surplus and modest FDI inflows, the euro basic balance has recovered to a healthy €400bn annual surplus.

 

Figure 1: Huge improvement in euro flows

The euro’s hidden outflows

Despite this improvement the euro hasn’t appreciated against the dollar. The EUR/USD rate – currently around 1.11 – has lagged in the past two years instead of steadily moving closer to 1.40 as many expected. The currency’s failure to move higher indicates an important regime break in flows, as negative dynamics in other parts of the balance of payments become more relevant marginal drivers of the currency.

 

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Figure 2: Euro basic balance suggests EUR should be much higher

Economic fluctuations

80%

of all European outflows comprises financial derivatives and other investment in the financial account

Estimates suggest just over 15% of the Euro-area’s basic balance surplus is offset by outflows in the capital account, which mostly relate to transactions in non-produced non-financial assets such as natural resources, licences or leases. The main share comprises financial derivatives and other investment in the financial account, representing nearly 80% of all European outflows. These categories include cross-border hedging, funding and financing activity.

The biggest component of the negative “other investment” income balance is banks, with outflows dominated by the currency, deposit and loan component. These large outflows from European banks to the rest of the world include money transfers. On the outflow side, money granted by Europeans to foreigners classifies as a loan (if the money is given to a bank) or a deposit (if the money is given to a non-bank). On the inflow side, money taken by European non-banks from foreigners is considered a loan while money taken by a European bank is a deposit.

According to Saravelos, two main drivers behind the large pick-up in European outflows are:

  • A big reduction in foreign inflows, as foreigners no longer wanting to hold euros have stopped depositing or lending money to Europeans.
  • A sizeable rise in European outflows, as Europeans lend/deposit euros and other currencies with foreigners. The combined net currency and deposit outflow from European banks to foreigners is at a post-crisis record high.

The report notes that in accounting terms, the eurozone effectively lends euros to the rest of the world to buy European goods. The euro’s weakness in the past two years in the face of such a huge swing in the composition of the balance of payments sends an important signal on the marginal driver of the weakness: an evident “excess” supply of euros despite the lack of portfolio outflows.

Beyond the balance of payments

Cross-border issuance of corporate bonds in euros in 2019 exceeded dollars for the first time as the European market became global destination of choice for international issuers.

At the same time, evidence points to rising cross-border carry and funding activity in the euro. The ECB’s tracking of European bank lending to foreigners shows a sharp acceleration in offshore lending from early 2017. Euro-area lending to non-residents has since returned to pre-Lehman highs – as European banks re-open their lending spigot to the rest of the world. The Bank of International Settlement (BIS) also reports a sharp acceleration in non-European bank liabilities in euros over the same period.

This increase in global euro borrowing coincides with a peak in dollar funding. Total cross-border dollar claims have plateaued since 2017, and while the absolute level of dollar funding over the period remains high, euro borrowing has sharply accelerated to far exceed dollar funding in growth terms .

The euro’s growing importance in global funding extends beyond bank lending. Cross-border issuance of corporate bonds in euros in 2019 exceeded dollars for the first time as the European market became global destination of choice for international issuers. Eurozone bank repo activity with non-eurozone counterparts is the highest on record this year as foreign banks become active in European repo and collateralised lending activity.

 

The euro is primed to become a funding or liability currency of choice, with several reasons to support this forecast.
Figure 3: Issuance of euro bonds now exceeding dollar bonds

The euro is primed to become a funding or liability currency of choice, with several reasons to support this forecast. They include high and still rising levels of excess euro liquidity caused by quantitative easing (QE); negative rates and highly concessional term funding via the ECB’s targeted longer-term refinancing operations (TLTROs), which provide a highly accommodative set of financial conditions for euro borrowers.

Against this in US markets dollar liquidity was contracting until recently and the absolute level of US yields remains the highest in the world. Recent funding volatility in US markets is likely to have exacerbated these differences: the divergence in dollar versus euro rates compared to the rest of the world has never been higher.

 

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Figure 4 : Never before have European yields been so low versus their US counterparts

Implications for the euro exchange rate

Quantifying the impact of this funding activity on FX is near-impossible. For example an international bond issued in euros could be accompanied by FX hedging, resulting in a net currency impact of zero. Or it may be left unhedged when the corporate willingly takes on the FX risk.

What’s pertinent for the currency is the marginal change in aggregate demand and supply. The report examines various contributory factors and concludes that the marginal driver of the euro over the past two years has shifted away from portfolio and trade flows to financial derivatives and other investment – mainly comprising cross-border hedging, funding, and financing. The supply of euros originating from this type of activity have kept the currency weak. This dynamic hasn’t been seen before now for the euro but one very similar applies to the Japanese yen: the relationship between the yen and traditional balance of payments metrics has long been weak, but has been much stronger for other components of Japan’s balance of payments.

Saravelos concludes that the FX implications of this shift in the euro are multiple:

  • While traditional balance of payments analysis based on portfolio and trade flows is losing relevance, hedge ratios on the stock of underlying assets, international liability management considerations and euro funding of international assets are growing in importance.
  • Trend-following behaviour will become more important for the eurobecause the marginal driver of the currency is shifting away from underlying transactional demand for portfolio assets or trade flows to underlying expectations of FX.
  • International use of euro funding reflects market expectation of the euro staying weak, so abrupt shifts in such expectations or price action potentially generate band-wagon effects. The euro is likely to exhibit increasing carry trade behaviour where depreciation is gradual but appreciation pressure sharp, as positions are unwound.
  • The euro’s rise as an international funding currency has global implications. The International Monetary Fund (IMF) and other bodies regularly highlight financial stability issues relating to dollar funding. However little attention has been paid to the euro – although rising global exposures to euro funding promise to introduce important FX and liquidity risks for corporates, investors and banks.

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