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The Reserve Dilemma

Worried about central banks exiting dollars? Here's what to do.

This column was originally published on RealMoney on Nov. 13 at 7:37 a.m. EST. It's being republished as a bonus for readers.

The persistent worry about the U.S. current account deficit has subsided -- and been replaced by anxiety over the vast accumulation of central bank reserves and the risk of diversification out of dollars. This concern seems exaggerated, but it's unlikely to go away anytime soon.

In recent weeks, both the Swiss and Russian central banks became the latest to announce a shift in the compositions of their official reserves, away from dollars. Recently Chinese officials intimated that their reserves had reached the unprecedented level of $1 trillion. Japanese reserves aren't far behind. On Nov. 8, Japan announced its reserves had risen by $4.28 billion in October to a new record high of $885.55 billion. The risk that Japan, and to a greater extent, China, decide to diversify the composition of their reserves weighs on dollar sentiment.

There has been persistent talk in recent days that Asian central banks have been buying euros and/or sterling, and the scuttlebutt suggests this demand will be a market feature going to the end of the year. Yet there is very little evidence of foreign official dollar sales. Consider that the indirect bidders, which includes foreign central banks (and other institutional investors as well), bought a greater share of the new 10-year note sold on Nov. 9 than in any Treasury auction since February. The

Federal Reserve

acts as a custodian for some foreign central banks and international accounts. Its custody holdings (Treasuries and Agencies) have risen by $17 billion since the middle of September, $12 billion of which has been purchased in the last three weeks.

Recall also that the Treasury's International Capital (TIC) report showed that foreign investors purchased a net $119.5 billion of U.S. bonds and stocks in August, a record amount. The U.S. Treasury's data indicate that far from selling, Chinese investors have been net


of U.S. Treasuries every month since last November, for a cumulative increase of $36 billion. In August, which are the latest data available (the September report is released on Nov. 16), Chinese investors owned more U.S. Treasuries than ever ($339 billion).

The situation in Japan is less favorable. Its holdings of U.S. Treasuries peaked in August 2004 at almost $700 billion and have trended gently lower since. As of August, Japan's holdings of U.S. Treasuries stood at $644.2 billion, down from $669 billion at the end of 2005.

Chinese official comments have been clear. They recognize China has accumulated a vast amount of reserves that pose a certain management challenge. Officials appreciate that the moves to diversify out of dollars risk undermining China's remaining reserves. Chinese officials, including People's Bank of China Governor Zhou, said this week that the nation is seeking ways to diversify the dollar component of its reserves from Treasuries to higher-yielding dollar paper. Zhou suggested that he was looking at a wide range of instruments. The dollar-denominated bond market extends well beyond U.S. Treasuries and Agencies. It includes corporations and non-U.S. sovereigns or quasi-sovereigns.

Knowing the Knowable

The composition of the world's nearly $4 trillion in central bank reserves is shrouded in mystery. Major industrialized countries reported the composition of their reserve holdings to the International Monetary Fund. However, their share of total reserves is modest and even more so if Japan is excluded. Currency reserves are highly concentrated. Six countries -- China (including Hong Kong), Japan, Taiwan, South Korea, Russia and Singapore -- account for more than two-thirds of the world's currency reserves. The composition of half of the developing countries' reserves is not reported to the IMF. This lack of information complicates discussions of the dollar's share of reserves.

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What we do know is that the dollar's share of the reserves of the advanced industrialized countries has not changed very much. If anything, perhaps owing to the massive intervention in late 2003 and early 2004 by the Bank of Japan, the dollar's share actually may have increased slightly compared with the roughly 66.6% average of the 1995-2004 period. The euro is the second most important reserve currency for these countries. However, it remains smaller than the sum of its parts; prior to the preparations for European Economic and Monetary Union (EMU), the Deutschemark, French franc and ECU (European Currency Unit) accounted for 32.7% of industrial countries' reserves.

Of the half of the developing countries reserves for which the composition is known, there is indeed evidence of diversification away from the dollar. There has been a steady decline in the dollar's share since peaking near 72.5% at the end of 1997. The most recent data put the dollar's share below 60%.


Some observers seem to believe that a decline in the dollar's share of reserves is tantamount to a divestment of dollars. But this is not necessarily the case, and does not in fact appear to be the case now. As the demand for reserve assets grows, the number of dollars, euros and British pounds (Russia and Switzerland recently acknowledged having bought yen for reserve purposes, too) may increase.

Nor does the diversification of reserves necessarily entail the sale of dollars. The Bank for International Settlements estimates that since the mid-1990s, a fifth to a quarter of the official dollar-denominated reserves is held in non-U.S. investments offshore. There are many reasons a foreign central bank would hold dollars outside the U.S. A BIS paper argued that country risk factors may help explain such an investment strategy. While the U.S. is loath to confiscate foreign assets in the U.S., there are numerous cases of its having frozen assets. Also, on occasion, U.S. courts have put liens on foreign assets. In addition, foreign officials may want to diversify their trading operations and build in some redundancies for security purposes in the same way that private sector financial institutions do.

The desire to improve returns is encouraging some central banks to adopt more active management for at least part of their reserves. Singapore has been one of the pioneers of more active reserve management. The IMF estimates that in 2003, 14-20 central banks allocated some of their reserve management to private fund managers.

What Not to Expect

It seems unreasonable to expect a central bank to preannounce to the world its reserve allocation decision. Nations simply don't do that. Consider China; it's trying to prevent speculators from profiting from the adjustment of the yuan's value. Are we really to expect that Governor Zhou will tell these same speculators that the PBOC is going to sell dollars so those speculators can sell in front of the central bank?

It's not clear how the reserve dilemma is played out. It's not immediately obvious that there is another currency that is broad and deep enough to rival the dollar-denominated market. What about the euro market? Because of the different tax regimes, issuance schedule and modest size of any one offering, the sovereign euro-denominated bond market is more like the U.S. municipal bond market than the deep and broad U.S. Treasury and Agency market.

A clear and viable alternative to the U.S. dollar would seem like a necessary condition for a true resolution of the dilemma. Perhaps the way Europe has sold gold might be a useful precedent. Although the Bretton Woods system collapsed because a few European countries wanted gold rather than dollars and U.S. President Nixon unilaterally refused the request by closing the gold window, a few years ago European countries decided they now had too much gold. To avoid a competitive panic, they colluded to achieve an orderly market agreement that limited the annual sales -- stretched them out for several years -- with little market impact net-net.

Investors should not expect a heads-up from foreign central banks until after they make their adjustment. Instead of reacting to what officials say, investors concerned about the diversification of reserves out of dollars should focus on what foreign central banks are actually doing. Watch the TIC data, Federal Reserve custody holdings and participation at U.S. auctions to monitor the situation.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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