Is there capital flight out of the Euro zone? (The Great Euro Bank Run in July)

The stunning revelation on June 8 that Swiss FX reserves jumped by almost CHF 80 bn in May – taking FX reserves from 28% to 43% of GDP in one month – raised fears of capital flight from the Euro zone. In the absence of hard data, it is impossible to say what drove this spike in reserve accumulation, but it seems likely that this data point is something of an outlier, driven by short term panic after Germany’s surprise announcement of a short sale ban on May 18.



At a purely conceptual level, the ongoing sovereign crisis on the Euro zone periphery does raise the possibility of capital flight, with Euro zone depositors potentially shifting their savings to safe havens like Switzerland and foreign investors pulling out of Euro zone assets. In today’s daily, we sift through the available data on capital flows out of the Euro zone, looking for signs of capital flight. Because Euro zone data are only available through March and thus pre-date the serious escalation of the Euro zone crisis, we focus on Japanese and US data which are available for April. We examine foreign investor behaviour in this already highly relevant month – European stocks and bonds were already starting to sell off quite hard from mid-April – but caution that they cannot tell us how Euro zone depositors are acting. Moreover, the crisis deepened in May and this may have changed the capital flow picture further.



Data on Japanese and US portfolio flows do not paint a picture of capital flight. This underscores our argument in the most recent FX monthly that the preponderance of evidence points to plain EUR selling – IMM positioning and risk reversals are stretched – while evidence of an underlying asset allocation shift out of EUR is weak. Of course, selling of liquid EUR can predate later asset allocation shifts in less liquid underlying assets, but we see the available data as underpinning our view that EUR/$ has only limited further downside, as embodied in our revised forecast.



2. Japanese investors are not yet penalizing the Euro zone, ...



Data on Japanese outward portfolio flows show that Japanese investors repatriated investments from the Euro zone in April, at roughly the same pace as in the previous 2 months. Overall, however, portfolio outflows from Japan fell back sharply, so this repatriation did not benefit any other country or region. To filter out noise in monthly portfolio flows, we construct 12 month rolling sums to assess the underlying trends. This shows that the 12 month outflow from Japan to the Euro zone has gone from JPY 4.8 tn in Aug-09 to JPY 0.6 tn in Apr-10, a drop of JPY 4.2 tn. Over the same period, the 12 month outflow to the US has fallen from JPY 9.1 tn to JPY 4.8 tn, a drop of JPY 4.4 tn. This does not paint a picture of capital flight from the Euro zone specifically, more of a general scaling back of risk in the face of growing uncertainty.



3. ..., but they are discriminating more among Euro zone assets



Of the JPY 4.2 tn drop in 12 month portfolio outflows to the Euro zone between Aug-09 and Apr-10, around 50% is explained by a reduction in outflows to France, 20% by a decline in flows to the Euro zone periphery (Greece, Ireland, Portugal and Spain), and 13% by a fall in flows to Germany. On a monthly basis, Japanese investors have continued to channel funds into German assets, while they have been selling French and periphery assets. There is thus clear evidence of greater differentiation among Euro zone countries, benefitting primarily Germany, though we should note that the sharp reduction in flows to France could be a reflection of liquidity, with Japanese investors better able to sell assets in the core than on the periphery. As always, bond related flows dominated Japanese portfolio data. Equity flows to the Euro zone have ground to a halt on a 12 month basis, a possible indication of a re-rating of the growth outlook in the Euro zone.



4. Meanwhile, US investors are still buying Euro zone assets



The April Treasury International Capital (TIC) report, which summarizes portfolio flows into and out of the US, paints a completely different picture. It suggests that net portfolio flows from the US into Euro zone stocks and bonds are still substantial, to the tune of $16 bn in April, which is roughly the same order of magnitude as prior to the global financial crisis in early 2007, so a very healthy pace of buying. Moreover, net flows into the Euro zone periphery were strong in April (around $5 bn), and they were positive for France ($2 bn), while flows to Germany were negative (-$2 bn). In essence, there is little evidence of a crisis of confidence among US investors in the Euro zone – at least in April.



5. No sign of portfolio allocation away from the Euro, yet



Overall, the picture is not one of foreign investors making a portfolio allocation away from Euro zone assets, and we re-emphasize that European stock and bond markets were already selling off quite hard from mid-April. This underscores our underlying view that investors will continue to hold their short Euro hedges for a while, but not re-allocate the actual assets much, which is implicitly what underpins our stronger EUR/$ forecast on a 12 month basis. That said, as May’s dramatic jump in Swiss FX reserves showed, the situation remains fluid and room for policy mistakes ample. We will continue to watch for changes in the data, most obviously in next week’s BoP release for the Euro zone.