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Central Banks Lead Subtle Shift Away From Dollar

Tuesday, 03 Nov 2009 04:42 PM

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NEW YORK -- Central banks with trillions of dollars in reserves that are already stepping up euro and yen purchases will likely continue doing so in coming years, driven by worries over the stability of the greenback.

A record U.S. budget gap and the rise of dynamic developing economies like China suggest the dollar, down over 20 percent since 2002 on a trade-weighted basis, has further to fall.

Of course, the dollar comprises some two-thirds of global reserves and will remain dominant in most holdings, as attempts to dump it would destroy the value of central bank portfolios.

But with the speed of reserve accumulation increasing after a crisis-induced lull late last year, policy makers can choose to park more new cash in euros and yen without having to sell existing dollar assets.

"I think 2009 will be remembered as a watershed moment for currencies," said Neil Mellor, strategist at BNY Mellon, which has some $20 trillion in assets under custody. "I don't think there will be an imminent move, but it is quite clear there's a plan to shift reserves to a more balanced portfolio."

Barclays Capital research showed that central banks that report reserve breakdown put 63 percent of new cash coming into their coffers between April and July into non-U.S. currencies.

"There's an incipient desire to reduce the dollar share of reserves, and central banks will use any opportunity to do it, provided it doesn't cause the dollar to fall out of bed," said Steven Englander, chief U.S. currency strategist at Barclays.

International Monetary Fund data shows the dollar's share of known world reserves has been declining since it stood at 72 percent in 1999, the year the euro was introduced. As of the second quarter of 2009, it accounted for 62.8 percent.

To be sure, some of that shift is driven by the dollar's decline against a basket of currencies over that period.

But the Barclays data, which removes valuation effects, shows the second quarter was the only one in which central banks accumulated more than $100 billion in reserves and put less than 40 percent into dollars, down from a 70 percent quarterly average back to 2006.

Overall reserves rose 4.8 percent to $6.8 trillion in the second quarter, the IMF said, the first increase in a year.

CATCHING UP TO THE DOLLAR

Policy makers acknowledge the dollar will remain a linchpin of global finance for many years to come. But it has fallen steadily on a trade-weighted basis over the last decade, a troubling sign for China, Russia, India and other big U.S. creditors holding trillions of dollars of U.S. Treasury debt.

Worries about record deficits, run up as the United States borrowed hundreds of billions to stimulate an economy ravaged by financial crisis, has further diminished foreign demand for U.S. assets, making it likely the dollar will weaken further.

For a graphic of the dollar's declining share of known reserves and rising U.S. budget deficit, see: here

And as others catch up to the United States, the dollar will share the stage with other currencies, said Barry Eichengreen, an economics professor at the University of California at Berkeley.

"The big beneficiary in the short run will be the euro, as only it has the requisite liquidity," he said. "But there's no reason why we shouldn't look forward to the advent of a multipolar reserve currency system."

The euro's share of known reserves hit 27.5 percent in the second quarter, from 18 percent in late 2000, IMF data showed. Analysts say it could exceed 30 percent in coming years.

The yen and sterling also stand to gain, while currencies from commodity exporters such as Australia may see more buying, Mellor said, particularly by energy-hungry emerging economies such as China, which holds $2.3 trillion in reserves.

Barclays' data showed claims in "other currencies" beyond the big four -- dollar, euro, yen, sterling -- rose more than 10 percent between April and July.

China does not report currency composition but is widely thought to hold around 70 percent in dollars.

Russia, the third biggest reserve holder with $419 billion in its war chest, says it holds some 47 percent in dollars and 40 percent in euros but wants to buy more of other currencies.

Central banks are also turning to gold, which Wells Fargo global economist Jay Bryson said may partly explain gold's surge to record highs.

Taiwan, the fourth largest reserve holder, has said it is considering buying more gold, while China said in April it had increased gold holdings by 75 percent since 2003. This week, India bought 200 tones of gold from the IMF for $6.7 billion.

DON'T COUNT DOLLAR OUT

Central banks do face limits on how they diversify their reserve holdings. Most currencies are simply not deep enough to accommodate massive sudden inflows and outflows.

Even a big shift from dollars to euros begs the question of which country's debt to buy. No European government bond market is as deep as the U.S. Treasury market, and bonds with the highest yields are from countries with the weakest economies.

"If you buy a 30-year Italian government bond, is Italy still going to be in the euro zone 30 years from now?" said Bryson. "Probably, but there is a risk there."

And while China's economy is on track to one day become the world's biggest, the yuan won't be a viable reserve candidate until China loosens controls and lets foreigners invest freely.

"That is a matter of decades, not years," said Anne Krueger, a former IMF deputy director now at Johns Hopkins University's School of Advanced International Studies.

Edwin Truman, a senior fellow at the Peterson Institute for International Economics and a former Federal Reserve economist, says it's "not so much a drift away from the dollar as it is a drift to other currencies."

"Will the dollar share of reserves be lower five years from now?" he asked. "If I had to guess, I'd say, 'yes.' Will it be because of a massive stampede out of dollars? Probably not."

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