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Ignore Noise About Dollar's Demise

Marc Chandler

In my last column, I examined several investment themes that could come into play in 2007. In the spirit of having to re-learn this coming year (as I do almost every year) that our best trade is frequently the one we did not make, the wreck we avoided, I'd like to suggest a theme that might get a lot of airplay but is probably really a distraction.

The reserve diversification issue may be for the foreign-exchange market what the Y2K issue was for the general public. The topic has generated a lot of heat but very little light.

Unimpressive Numbers

Earlier this month, the Financial Times ran a front-page story about how oil producers were "shunning the dollar." This "shunning" was a reference to data from the Bank for International Settlements' quarterly report, which noted a roughly $5.3 billion decline in dollar-denominated deposits among Middle East oil producers in the second quarter of 2006. But a subtle detail was lost on many observers: the fact that yen-denominated deposits rose slightly more than euro-denominated deposits.

This week, the United Arab Emirates' confirmation that it plans to shift $2 billion of its dollar-denominated reserves to euros in the coming quarters also captured the imagination of pundits and observers. This followed hard on the heels of word that Iran is not only shifting its reserves into euros but has begun invoicing its oil sales in euros rather than dollars -- more evidence, we're told, of the dollar's demise.

This makes a good talking point only if one plays down the modest size of the numbers involved and ignores other important data. The $5.3 billion decline in dollar-denominated deposits in the Middle East still means that 65% of the deposits are in dollars.

The takeaway from the UAE's decision is the same; after implementing its diversification program, the UAE still will have 90% of its reserves in dollars. Its diversification program entails the sale of about $2 billion over the next several quarters, which can be easily absorbed by the foreign-exchange market, where the turnover is estimated at $2.5 trillion a day or more.

Not a Trend

That claim countered, pundits would proffer that it's not that these numbers are significant in themselves but in what they represent, being just the tip of the proverbial iceberg. While this is possible, it still seems unlikely. Surely the wars in Iraq and Afghanistan have educated us all on some of the fragmented nuances of Middle East politics. By now, few must really believe that most of the region will follow Iran's leadership in general and financial matters specifically.

The Treasury's TIC data shed light what is really going on. The most recent data cover October 2006, and indicate that OPEC countries held $97.9 billion in U.S. Treasuries. That's up from $75.4 billion in October 2005 and $62 billion in October 2004. Whatever diversification is occurring did not prevent OPEC from buying more Treasuries in the past 12 months than in the prior 12 months or the 12 months before that.

China has amassed more than $1 trillion in reserves and serves as the focal point for many observers who are concerned about the impact of diversification. Yet China holds more Treasuries now than ever before. The nation's holdings have gone up for the last 12 consecutive months without fail. In the first 10 months of 2006, China's U.S. Treasury holdings increased by $31 billion.

It is true that China's Treasury holdings increased by $78 billion in the January to October period in 2005, but this points to another aspect of the diversification story: diversifying out of Treasuries into other and higher-yielding, dollar-denominated paper such as agencies and corporate bonds as well as dollar-denominated bonds issued by other countries, such as Germany's KfW.

The TIC data indicate that foreign investors made a net portfolio investment of about $875 billion during the first 10 months of 2006. During a year in which the diversification story reached a fevered pitch at times, foreign investors probably matched if not surpassed 2005's record $1.2 trillion in purchases of U.S. assets, including direct investment.

Among the most fickle investors in U.S. Treasuries are not foreign investors but the American investors who take advantage of the tax-free havens in the Caribbean. The Caribbean community sold about $9 billion of U.S. Treasuries in the January-October 2006 period, more than offsetting the $2 billion bought during the entire calendar year 2005.

More recent data than the October TIC report suggest there's less to the reserve diversification story than meets in the eye in the press or on television. The Federal Reserve offers some basic custodial services to foreign central banks. It reports its holdings for them every Thursday. In December, the Fed's custody holdings for foreign official accounts swelled by about $34 billion, on top of a gain of $18 billion in November. The December rise is a little bigger than the increase recorded during the August-November period.

Stay Independent

What does all this mean for the dollar's outlook? It means that one needs to arrive at a view independent of what the central banks may or may not be doing. And it suggests that in periods when overall reserves are growing and financial assets are growing, diversification can take place without dollars having to be sold on a net basis.

The nearly 14% rise of sterling against the dollar this year and the just more than 11% rise of the euro probably contributed more to the diversification of reserves and foreign-exchange deposits than outright dollar sales.