Forex Blog: Currency Trading News & Analysis.

June 17th 2009

Reserve Diversification Gains Momentum, but Still a “Distraction”

The Dollar’s status as global reserve currency was a subject of discussion at two multilateral meetings this week: G8/G20 and BRIC. At the first ever BRIC meeting of the four largest developing economies (Brazil, India, Russia, China) the result was a consensus decision to explore reserve diversification further, while “developments at the Group of Eight meeting of finance ministers helped reinforce the currency’s status as global reserve currency. The statement that emerged from the meeting in Lecce, Italy did not specifically mention currency markets.”

One of the motivations for convening the meeting between the BRIC companies may have been to convey the growing opposition to the Dollar. “The June 16 gathering of the BRICs is the biggest show of unity yet in their bid to win more financial influence — while they take jabs at the U.S. Russian President Dmitry Medvedev said on June 5 that using a mix of regional currencies as a global reserve rather than the dollar would help stabilize the world economy.”

While much of this represents posturing as part of the global power game, there is a certain amount of pragmatism reflected in this attitude. After all, the U.S. is projected to run a $1.85 trillion deficit in 2009, bringing the total debt held by the public close to $10 Trillion. Meanwhile, the Fed – through its quantitative easing plan – is both facilitating this debt and potentially stoking inflation.
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As a result, “The BRICs are putting the U.S. on notice that there has to be a cutback on spending and get their house in order.” The BRIC meeting yielded $70 Billion in commitments to enhanced IMF bonds- commitments that would presumable be funded/collateralized with sales of US Treasury bonds. “The debt will pay a yield similar to Treasuries and will be denominated in the fund’s basket of currencies, known as Special Drawing Rights…The IMF calculates the value of SDRs daily, with 44 percent weighted toward the dollar, 34 percent to the euro and the remainder split between the yen and the pound.”

At the G8, however, participating countries were practically competing with each other to voice their support for the Dollar. “Japanese Finance Minister Kaoru Yosano said his nation’s confidence in U.S. debt is ‘unshakable‘ and that the currency’s global status is safe.” Then, “Officials at Asia’s richest central banks said they would shrug off a U.S. sovereign credit rating downgrade — a topic of speculation recently in markets — and continue to buy Treasuries to keep markets stable.” Even Russia, which was simultaneously denigrating the Dollar to its fellow BRIC members, “said the dollar’s role as the world’s main reserve currency is unlikely to change in the near future.”

For several reasons then, many analysts view the diversification talk as a distraction, especially as it bears on the forex markets: “The raging debate about the future of the U.S. dollar’s reserve currency status may be masking the real drivers of its near-term direction.” First of all, contradictory and ambiguous statements reveal a complete lack of consensus, not only about whether the current system should be abandoned but also with regard to what form an alternative system would assume. For example, neither the Euro nor the Chinese Yuan represent viable alternatives, since the former is too new and the latter is still not fully exchangeable.

Thus, their threats to dump the Dollar have actually been accompanied by an increase in Dollar purchasing, which is required to maintain their currency pegs. “Periods of dollar weakness are therefore met with official dollar purchases…global reserve accumulation, which peaked about $7 trillion last summer, has resumed as the dollar has weakened since March.”

Second, even if Central banks and governments decided to make change, it would take years to implement. “The evolution of a reserve currency would be exactly that, an evolution, not an overnight change,” said one analyst. Another added, “The choice of a reserve currency is not made by central bankers; it chooses itself.” In other words, investors will flock towards currencies that are characterized by liquidity and openness and backed by strong capital markets, not on the basis of politics.

This leads to the third and perhaps most important point, which is that capital flows by private investors dwarf movements by Central Banks, especially in the short-term. While Central Banks are and should be taken seriously by forex markets because of their size, they still account for only one portion of global (Dollar-denominated) foreign exchange holdings. In the short term, investors will continue to move capital around in accordance with their risk/reward profiles. Barring a sudden shift by Central Banks away from the Dollar (which would be counter-productive and a losing proposition), then, it is these private capital flows which will shape the Dollar’s future in the near-term.

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Posted by Adam Kritzer | in Central Banks, News, Politics & Policy, US Dollar | No Comments »

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