Thursday February 9, 2006 - 16:13:10 GMT
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Reserves represent dollar risk
The issue of global dollar reserves, held mainly in Asia, will remain an extremely important market issue. The US and Asian countries both have a powerful interest in avoiding a destabilising plunge in the dollar and a sharp weakening in the US economy. Slow and measured 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 could destabilise rapidly, especially if individual central banks start to sell dollars more aggressively as this could lead to a cascade of dollar selling. These risks will increase if there is greater internal opposition to rising reserves in Asia.
For now, confidence in the US economy and Fed policy should remain strong enough to maintain dollar investments. The equation is liable to shift rapidly if the US economy deteriorates, especially if there is an increase in trade protectionism in response to an economic slowdown. The risks of a destabilising dollar collapse and global turmoil will, therefore, still be a significant risk during 2006.
Dollar doubts likely to return
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 consideration for the past two years at least as Asian reserves have risen to unprecedented levels. The issue retreated to the background to some extent during 2005 as the dollar rallied against most major currencies, easing fears over dollar selling, but it is liable to return to prominence over the next few weeks and months.
Massive increase in reserves
Japanese central bank reserves are over US$830bn while Chinese reserves are also above US$800bn after a huge increase of over US$200bn over the past year. Over the past few weeks, there has been evidence of intervention by the Korean central bank to alleviate current strength and this will continue to inflate reserves levels. Asian reserves overall rose by over US$250bn in 2005 and the total for the top eight Asian central banks is now close to US$2.60trn with around US$1.70trn of these probably denominated in dollars.
Given the scale of reserve holdings and the rapid increase over the past two years, there has been increased concern over the implications of a switch out of the dollar. Despite a gradual increase in Euro use, over 65% 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$400bn 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. Even if there is no diversification of existing reserves, any slowdown in the buying of new dollars and US securities would substantially weaken underlying global dollar demand.
China changes will be important
Following the July 2005 Chinese decision to revalue the yuan against the dollar and give it at least partial flexibility, there will be increased pressure to mange reserves on a trade-weighted basis. There will be pressure for the dollar proportion of reserves to be cut, especially as China‚Äôs currency market is likely to be liberalised further over the next few months. This is particularly important as the dollar has less than a 50% weighting in the yuan basket and sustained dollar depreciation would increase pressure for dollar reserves to be scaled back. In theory, China would be justified in cutting the dollar proportion of reserves sharply. In other Asian markets, links to the dollar are liable to weaken and this will lessen demand for dollar assets to be held.
There will be a further debate not only on the currency composition of reserves, but also the asset weightings. There is pressure to boost returns and place the reserves either in high-yielding assets or in more productive domestic 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. There is likely to be increased public opposition to excess dollar holdings.
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 and gradual adjustment would be preferable to a much larger and disorderly adjustment later. The difficulty, however, is that it will be very difficult to control any move out of the dollar and prevent a more destabilising market trend.
Asian incentives for stability
Asian economies are still dependent on strong US demand to support their export sectors. If there was a very sharp dollar decline, the risk of a US recession would also intensify. Any 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 relatively low. If yields start to rise, this would 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. Higher bond yields would also slow the US economy and present a risk to the US housing sector.
What are the alternatives?
The dollar will continue to gain some protection from the fact that there is a shortage of viable alternatives to the dollar. On a long-term perspective, the Euro is still a relatively young and untested currency, while the yen still has a relatively small global role. The US Treasury market also remains the most liquid global bond market. There is, however, likely to be a gradual increase in Euro and yen use over the next few months.
US economy vital
The US economy has continued to perform well over the past few months with solid growth and still low inflation while the Federal Reserve has, so far, successfully managed the transition to higher interest rates. While the US economy is performing strongly, investment flows into the US will remain strong.
Any significant deterioration in the US economy would risk an outflow of investment funds. There will also be increasing political risks if US growth slows as there would be increased domestic calls for trade protectionism and stronger Asian currencies. The 2006 US congressional elections will need to be watched closely as trade policies will be very important if US unemployment starts to rise.
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 under pressure. Over the past few years, central banks have generally been very astute with their market timings and their 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. The risks of a rapid dollar collapse should certainly not be ignored during 2006.
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