The dollar’s descent
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Emerging Markets

The dollar’s descent

Fears of the greenback’s demise are growing, especially as central banks increasingly move to diversify their reserves. How far will the reserve managers go – and could the dollar lose its international role?

The merest hint that the US dollar could lose its primacy as the world’s reserve currency can send markets into tailspin. Now the dollar – that defied the gravity of a growing US current account deficit in 2005 – is starting to fall again, reigniting concerns that foreign central banks could pull the plug and so advance the greenback’s imminent collapse.


China

No wonder that, when China indicated earlier this year it could begin to diversify its rapidly growing foreign exchange reserves away from the US dollar and government bonds, long-simmering fears of a run on the US currency started to boil again. Such a shift could, after all, have huge implications for global financial markets.


China’s top foreign exchange czar was understandably quick to quash speculation about a possible move to hedge against a falling dollar. “Until now we haven’t made a huge adjustment to our reserves composition because China’s foreign trade is largely in US dollars, so in the basket, the US dollar comprises a quite large portion of it, so there’s no need to shift greatly from this,” Hu Xiaolian, head of China’s state administration of foreign reserves told Emerging Markets in an interview in August.


She also pointed out that diversification was part of a long-standing practice of portfolio management that predates China’s exchange rate realignment last July.


“Over the past few years, we have already diversified our reserves away from exclusively US dollar to other currencies – euro, yen and we have also now moved to the Korean won – so that’s already evidence of diversification,” Hu said.


Analysts estimate that more than 70% of China’s reserves are invested in US dollar assets, which has helped to sustain the large US deficits. If China were to stop acquiring such a hefty proportion of dollars with its reserves – currently accumulating at about $20 billion a month – it could put heavy downward pressure on the greenback.

Analysts say an escalation in reserves diversification talk, along with an end to the US Federal Reserve’s tightening campaign, would prove damaging for the dollar.


GULF STATES

But China is not alone in its rumblings of reserve diversification. In July this year, when the United Arab Emirates confirmed its strategic decision in July to shift 10% of its $29 billion foreign exchange reserves into euros, the same set of fears resurfaced.


This time, talk was that politics had won out and forced the hand of one of the world’s better-stocked central banks to make the change. The UAE – which produces 2.5 million barrels of oil a day – was moving a portion of its reserves into euros following the March controversy over Dubai Ports (DP) World forced sale of its US operations after it met with political backlash in Washington.


UAE central bank governor Sultan Bin Nasser Al Suwaidi strenuously denied any such motives. In an interview with Emerging Markets, he pointed out that the move was made on purely economic grounds. “It is only a 10% shift we are talking about,” says Al Suwaidi. “It’s a normal issue, part of our normal diversification. We based our decision on purely economic reasoning.”


“We made the announcement [about diversification] prior to the DP World issue, but nobody took notice then. Only the international press took notice after the DP World problem.”


Of course, $23 billion in reserves is small beer – and $2.3 billion even less so. The big money in the UAE is in the Emirates’ different investment agencies, not in the central bank. Nevertheless, there is little doubt that a surge in dollar accumulation by dollar pegging Gulf states provided significant support for the dollar – and much financing for the US – in 2005. It’s unlikely that Gulf countries could shift heavily out of dollars without driving the dollar down.


Adding fuel to the fire, Qatar’s central bank governor Abdullah Bin Khaled al-Attiyah has said the bank could hold up to 40% of its reserves in euros. As of mid-2005, it held more than 90% of reserves in dollars. Kuwait’s central bank governor Sheikh Salem Abdul-Aziz al-Sabah pointed out this year that the bank is studying whether the euro is becoming more attractive.


The Saudi Arabia Monetary Authority (SAMA) manages a large part of the foreign exchange reserve assets in the Gulf. Its balance sheet reports near $200 billion-worth of foreign assets, but the actual figure is probably higher.


“They’re accumulating reserves so rapidly, I’d be astonished if they were not experimenting in ways to hold their reserves outside US dollars,” says Richard Cooper, professor of economics at Harvard University. “What they’ll discover is that they can diversify billions into non-dollar reserves, but they can’t manage tens of billions without buying assets they’d be uncomfortable about.”


Europe

Russia, whose central bank also holds vast sums of oil dollars, has also thrown its weight into the debate. Earlier this year its finance minister Aleksei Kudrin said that the dollar wasn’t the absolute reserve currency, and that the US swelling deficit could ultimately affect its stability.


“If a currency is used for different reserve purposes, reliability is needed,” Kudrin said. “The US dollar has not been very stable in the past years.”


Some European central banks, it seems, agree. This spring Sweden significantly reduced dollar holdings in its foreign exchange reserves. The Riksbank, whose currency reserves stood at $21 billion at the end of last year, said it reduced dollar-denominated assets by 17%, to 20%, and boosted its euro holdings by 13%, to 50%. It also cut its holdings of the Japanese yen, which had previously been at 8%, and increased reserve holdings in Norway’s krone by 10%.


What’s clear is that the dollar’s dominant role cannot continue to be taken for granted – the dollar might eventually lose its mighty status in international finance.


Barry Eichengreen, professor of economics at the University of California, Berkeley, thinks that talk of the dollar losing its international role is generally overblown. “To paraphrase Mark Twain, reports of the dollar’s death have been greatly exaggerated,” he says. “The dollar is still the dominant reserve currency for banks. The share of central bank reserves has been rising, not falling. The market in US Treasury securities is still the single most liquid financial market in the world.”


“The US dollar will remain the main currency for a long time. The euro won’t take over because of its characteristics,” says Al Suwaidi. “Think about where to invest the euro – the investment opportunities are limited. If you look at international trade, the dollar is a major player. International trade will bring them back to equilibrium.”


Case for diversification

On the other hand, former US Treasury secretary Larry Summers has been on the lecture circuit this year urging foreign central banks to disinvest in US securities. He argues that developing countries should find a better way to invest their money than in low-yielding US Treasuries.


“I do think there’s a strong case for central banks thinking about when they have very large reserves beyond those that would meet any immediate liquidity need, diversifying into a higher return though in the short term, riskier set of assets that could include equities, longer-term financial instruments, alternative investments,” Summers told Emerging Markets. “With the tremendous growth in reserves, that should be a very active area of financial consideration.” After inflation and currency changes are factored in, Summers reckons the return on Treasuries will be zero.


His point is that the opportunity cost of excess global reserves is vast. “If the wealth tied up in reserves were invested either domestically in infrastructure or in a fully diversified long-term way in global capital markets, 6% would not be an ambitious estimate of what could be earned. The resulting gain would be close to $100 billion a year,” he pointed out in a speech in Mumbai this spring.


Adjustment hope

Summers hopes that an adjustment will be forthcoming: “The US economy and the dollar will certainly be healthier if these adjustments take place more rapidly rather than less rapidly. Economies that have no net national savings are not terribly healthy economies, and that’s the situation of the US right now,” he told Emerging Markets.


His deeper point speaks to the perversities of today’s global economy. “It’s the irony of this moment that, while the international financial system has been traditionally conceptualized in terms of a flow of capital from industrial to developing countries, the net flows of capital are very much in the opposite direction.” Countries that need to finance development are shifting more money to the US than the other way around.


Summers’ proposal to reverse this trend is based on fundamental shifts in the global financial system that arose well after he left office – the immense build-up in the reserves of foreign exchange held by developing countries’ central banks. Those reserves have grown as the United States, with its burgeoning trade deficit, imports goods from abroad.


The dollars Americans spend on foreign goods eventually end up in the hands of foreign central banks, which in turn invest the proceeds largely in US government debt, partly to protect themselves against financial crises of the sort that struck Asia in 1997. For a developing country, accumulating dollars can help discourage speculators from trying to drive down the value of its currency.


But were China or Japan to foist a significant fall in the dollar, they too would suffer the consequences – sharply diminished exports plus a drop in the value of their substantial dollar assets. As Laura Tyson, dean of the London Business School and a former Clinton economic adviser, points out, “Asian central banks can’t – won’t – sell dollars. The effect on the holders of dollars would be too big.”

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