When Foreign Central Banks Diversify

After reading Marc Chandler's Columnist Conversation post on Asian central banks diversifying out of the dollar, I felt I should polish off a piece I was writing on a related topic that would answer the following questions: How do central banks diversify out of dollars? What would it look like? Who would be most likely to do it? Here goes:

In thinking about central banks diversifying out of dollars, there is sometimes a misconception of how central banks manage their balance sheets. The asset side of a central bank is typically composed of short- to intermediate-term debt instruments in a variety of currencies. At present, the dominant asset class for the world's central banks is short- to intermediate-term debt denominated in U.S. dollars. This isn't too surprising, because the U.S. has the deepest and broadest debt markets in the world. (Gold would be a better reserve asset, but today it is viewed as only a barbarous relic fit for an era of small governments.)

So assuming that it would be desirable to diversify out of dollars, how might a central bank do that? There are several ways:

Sell all U.S. dollar bond positions, and simultaneously use the proceeds to buy similar maturity positions in another currency. Small central banks could use a process like this to rebalance their currency exposure rapidly and cheaply, in a transaction-cost sense. Big central banks aren't likely to do this, because they would drive the market down as they liquidate U.S. dollar bonds.

As U.S. dollar bond positions mature, take the proceeds and invest them into a lesser proportion of U.S. dollar bonds. That proportion could be zero. This is a slow way to diversify, but any central bank can use this method. It is quiet, and it does not roil the bond and currency markets to the same degree as outright sales.

Do a combination of the above methods in the following manner: Liquidate the longer maturity U.S. dollar bond positions, exchanging them for positions in another currency, and let the rest slowly mature, and reinvest into fewer U.S. dollar assets. The market impact is in between the above methods, but it can be managed in a way that allows for faster diversification if the markets are favorable, and slower if the markets balk. Large central banks can do this, but they would have to be more gentle about the liquidation of U.S. dollar bonds.

All of these methods have a negative effect on the dollar and would raise U.S. interest rates, but the second method would be the most gentle, and the first method the most harsh. I view methods two and three as being the most likely for central banks to use, should they want to diversify out of U.S. dollars. If they use such methods, the only trace that they will leave behind is that they bid less at the Treasury auctions, and that the U.S. Treasury finds that fewer foreigners are holding U.S. dollar debt.

---

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.