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As Dollar Loses Reserve Status, Central Banks Diversify

The dollar's position as the world's reserve currency has wavered. Central banks are responding by diversifying.

  • David Turner

The dollar may still be the dominant reserve currency hoarded in central bank coffers, but it does not quite hold the commanding position of yore.

Its share has dropped from 71.5 percent of official forex "allocated reserves" at the beginning of the 2000s — forex reserves whose currency denomination is known — to just over 60 percent today.

In the meantime, though, no single currency has quite managed to usurp the greenback.

Instead, foreign central banks have favored a more diversified portfolio, according to IMF data. The combined share of allocated reserves held by the euro and dollar has dropped from just above 90 percent in mid-2009 to 87 percent only three years later. Is it possible that central banks will continue diversifying their forex portfolios — creating a wide range of currencies with an equally good, or bad, claim to be global reserve currencies?

The IMF numbers do not tell us which currencies account for this diversification: The lion’s share of it comes from the IMF’s mysterious "claims in other currencies" category. This figure, which excludes sterling, the yen and the Swiss franc, as well as the dollar and the euro, has quadrupled since late 2007 to $310 billion-worth. The increase in the overall share of allocated reserves held in "other currencies" has risen over the same period from only 1.8 to 5.3 percent.

Central banks are diversifying their currency reserves out of a "prudent desire for profit maximization," says David Marsh, co-chairman of the Official Monetary and Financial Institutions Forum (Omfif) in London, which exists to promote dialogue among government and private sector financial organizations. Marsh says central banks are trying to turn their forex reserves into "profit centers." Private sector investment managers seeking to earn a return from their portfolios usually choose to diversify, and to an increasing extent, central banks are no different these days. "Portfolio diversification theory suggests they should hold a greater number of currencies," says Marsh.

Which currencies are likely to gain from this? A little-noticed piece of recent news from the IMF gave a strong clue to investors as to what the up-and-coming reserve currencies are. In November it revealed that it was considering, from next year, requesting and then publishing data on the central banks’ forex reserves of Australian and Canadian dollars — a symbolically important move, which unofficially confers on them the status of reserve currencies.

Analysts say the progressive buildup, in recent months, of forex reserves at the Reserve Bank of Australia confirms that foreign central banks are eager to swap their own currency for the aussie. The aussie has even started behaving like a reserve currency. It has, this year, defied the usual gravitational forces that apply to normal currencies: The central bank’s benchmark rate has been slashed by 175 basis points (bp) since October 2011, but the Australian dollar appears profoundly indifferent. On the day of the latest interest rate cut, a 25bp fall announced last week, it even rose slightly against the U.S. dollar. At the close of Asian trading on Wednesday, it was worth US$1.05.

The aussie’s appeal to central banks lies partly in the robust, commodity-based growth of the Australian economy, and partly in the increasingly rare triple-A status of Australian government bonds — the vehicle preferred by foreign central banks for holding aussie-denominated assets.

Analysts say another largely commodity-based currency gaining a growing following among central banks is the Canadian dollar, which benefits from Canada’s large net oil exports.

Marsh estimates that official foreign exchange holdings "probably" total about $60 billion for each of the two currencies. Although $60 billion is less than 1 percent of total global reserves, "allocated" and otherwise, of $10.5 trillion-worth, it is a growing proportion.

Diversification makes sense for positive reasons, but there is also an important negative reason for its attractiveness: the unattractiveness of the two conventional reserve currencies, the dollar and euro.

The decline in the dollar’s share makes sense given global fears about the U.S. economy’s long-term future, say the many analysts who espouse a declinist view of the country. They see the dollar’s recent firmness as unlikely to last. "Because of continuing U.S. deficits and low domestic savings, the stock of U.S. debt held by foreigners has become so high that central banks and other investors are beginning to doubt the government’s ability to pay it back," says John Hummel, partner, president and chief investment officer of AIS Capital Management in Wilton, Connecticut. Hummel is bearish about the dollar.

The euro’s bid to be a reserve currency has, until recently, been aided by fears about the dollar. When the euro was launched in 1999, it accounted for 18.1 percent of official allocated reserves. By the second quarter of 2011, the figure was 26.7 percent.

However, the euro has problems too in the eyes of central bankers — not least the fear, ever since the euro zone fiscal crisis erupted last year, that its dominion might shrink or disappear altogether as the currency union disintegrated. Its share had slipped, by the second quarter of this year, to 25.1 percent.

"The two main currencies accounting for the bulk of reserves are undoubtedly showing strains," says Marsh of Omfif. He adds that this is "driving interest in currencies like the Australian and Canadian dollars."

The greatest long-term threat to dollar dominance may come from the renminbi, which is not so much the elephant in the room as the pachyderm slowly lumbering down the hallway towards it. China has the world’s second-biggest economy and is predicted, if present trends broadly continue, to overtake the U.S. to clinch the top spot within the next ten years. However, the renminbi can never become a reserve currency unless its strict capital controls are relinquished, allowing it to be bought and sold freely — a process that is likely to take several years at the very least. It is also possible that the ruling Communist party will remain forever reluctant to allow a fully convertible renminbi, because it would greatly reduce the party’s power to direct the economy as it sees fit.

With the euro and renminbi burdened by their own particular flaws as reserve currencies, central banks wary of excessive U.S. dollar dependence are likely to continue looking at smaller currencies — particularly, but not exclusively, those buoyed by commodity-based underlying economies. In addition to the Australian and Canadian dollars, Marsh says that a small number of central banks also hold the Korean won and Singapore dollar, for example.

However, analysts say that although this trend is likely to continue chipping away at the dollar’s share of total reserves, the unsuitability of the euro and renminbi are likely to keep the dollar’s decline as a reserve currency gradual rather than dramatic.