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Thursday February 24, 2005 - 14:32:35 GMT
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The benefits of reserves diversification

The issue of dollar reserves held globally will remain an extremely important market issue. The US and Asia both have a powerful interest in avoiding a destabilising plunge in the dollar and a gradual adjustment is still realistic. A gradual process of reserve diversification should also be welcomed as a market mechanism to ease US and global imbalances while lowering longer-term risks. A further aggressive build up of dollar reserves outside the US would intensify the medium-term economic risks and increase the threat of a very painful forced adjustment. The position will, however, remain precarious, especially if individual central banks start to sell dollars more aggressively as this could lead to a cascade of dollar selling. The risks of a destabilising dollar collapse and global instability will, therefore, still be high during 2005.

Dollar fears increase again

The issue of rising dollar reserves held by Asian central banks and the potential for dollar selling by central banks has been an underlying market concern for the past two years at least as intervention has pushed up Asian reserve levels to unprecedented levels. The issue came to prominence last November and, after some respite as the US currency rallied in January, the issue is back claiming the currency-market headlines.

Massive increase in reserves

Japanese central bank reserves are over US$800bn while Chinese reserves are above US$600bn. Asian reserves have increased to over US$2.20trn with around US$1.40trn of these probably denominated in dollars.

Given the scale of reserve holdings and the rapid increase, there has been increased concern over the implications of a switch out of dollar reserves. Despite a gradual increase in Euro use, over 60% of reserves are still held in dollars and any reduction to around 50%, for example, would be likely to put at least an additional US$300bn into the global market. The additional supply would tend to weaken the dollar and there could also be a very serious impact on wider dollar confidence.

The fears over central bank reserve diversification have been increased by the Korean government’s announcement that it would be looking to diversify reserves into non-government bonds which have higher yields and diversify the currencies in which it invests. This illustrates the fact that there is a debate not only on the currency composition of reserves, but also the asset weightings. There is pressure to boost returns and place the funds in more productive areas to support local economies. This is particularly pertinent in countries such as India and will be a growing issue in China and throughout Asia. The Korean authorities subsequently denied that they would be selling dollars, but there was still a significant reaction in global markets with the dollar dropping sharply. At the very least, there will be a slowdown in dollar accumulation and dollar selling will also certainly be a risk.

Market mechanism

Some diversification away from US dollar reserves should actually be welcomed as it will be an important mechanism in easing the US current account and budget imbalances. While the US has a captive buyer of US Treasuries, there will be little incentive or mechanism to lower US deficits and a further widening of the deficits would store-up even greater trouble within the next few years.

A gradual rise in US bond yields and gradual dollar depreciation would slow US demand and help increase the US savings rate, both of which will be vital elements in lowering the US current account deficit. There would also be additional market pressures for stronger Asian domestic demand and less dependency on export growth. A controlled adjustment now would be preferable to a much larger adjustment later. The difficulty, however, is that it will be very difficult to control the move and prevent a more destabilising market trend.

Asian incentives for stability

Asian economies are also dependent on strong US demand to support their export sectors. If there was a very sharp dollar decline, the risk of a more aggressive Fed response would increase and the threat of a US recession would also intensify. A sudden weakening of US demand would hurt Asian growth badly and there is, therefore, a strong incentive to maintain the uneasy balance that has existed over the past two years.

Asian central banks will also be happy to hold dollars if they can secure attractive returns in the US Treasury market. In this context, the increase in short-term US interest rates has not had the expected effect as bond yields have remained low. If, however, yields start to rise, this will lessen the incentives for switching out of US treasuries on yield grounds. There will, however, be an uncomfortable loss of capital as bond prices fall and the key issue is that the rise in bond yields will need to be orderly to prevent market destabilisation.

Market timing important

The risks of China and Japan aggressively reducing their dollar holdings are still low. The central banks will also be careful to avoid selling the dollar at its weakest point as this would compound capital losses. This suggests that they are much more likely to sell into dollar strength rather than dump the dollar when the US currency is already under pressure. Over the past few years, central banks have generally been very astute with their market timings and there reaction to dollar gains should be watched closely.

There will still be the risk that individual, smaller central banks will try and take a free ride by selling their own dollars and hoping that others do not follow suit. This could quickly develop a damaging momentum of dollar selling. Sharp dollar depreciation could then force panic selling in the markets and the risks of a rapid dollar collapse should certainly not be ignored.

 

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