Central Bankers' Fears As They Watch The Plummeting Dollar

Barclays, whose primary goal these days seems to be to enjoin the Fed in ruining the dollar (talk to a gummy bear salesman from Barclays and you will get a "short the dollar" pitch), presumably in order to make even more money on their alleged huge short dollar prop exposure, is out with a new note from currency strategist Steven Englander. His latest perspective is that all of today's conventional wisdom interpretations of IMF data demonstrating a diversification away from the dollar in global reserves is in fact not what it seems. If it were, the dollar would be at most worth zero, and at worst, the Fed would be paying you to take every new batch of brand new Obama-faced $1 trillion bills from its basement.

To wit:

IMF data show a drop in the USD’s share of reserves from a peak of 73% to just below 63% in Q2 09. Most of this is due to valuation effects, rather than any transactions by central banks. Its share has declined because the USD is not worth as much, not because central banks have been able to substitute other currencies for USD. Insofar as there is evidence of a change in central bank behavior, it is very recent (see Central banks walk the ‘not buying USD’ walk, 5 October 2009). If it were not for the changes in the USD’s value, its current share in reserve portfolios would be less than 1pp below the 10-year average and about 2.5pp below the peak.

The IMF COFER line shows a steady decline in the USD’s share in reserve portfolios based on its published headline numbers. These are the numbers most often discussed by journalists and investors (Figure 1). We also calculate what the USD’s share would have been if exchange rates had been stable during 1999-09. This would provide an estimate of how much USD has been actually bought or sold relative to other currencies, and eliminates valuation effects because exchange rates are held fixed. The values of the currency used are arbitrary and change only the level of the share, not its trend. We recalculate the USD’s share using exchange rates at: 1) Q2 01, when the USD’s share in the headline IMF data was at its peak; and 2) Q2 09, when its share hit its trough. Our calculations exclude the small “other currencies” category because there is no way to fix an exchange rate for this category. This omission has almost no effect on the outcomes.

And here is the punchline: basically the only reason reserve portfolios have seen a decline in the dollar is due to the ceaseless pounding the dollar receives only because it is cursed with being the currency of choice of the current batch of madmen in the Federal Lunatic Asylum Reserve.

If the value of the USD had not changed, its share in reserve portfolios would be virtually trendless. It does not matter whether exchange rates are from a strong or weak dollar period. As noted above, whatever FX rate is used, the Q2 level would be less than 1pp below the 10-year average.

In valuation-adjusted terms, the USD’s share hit a local peak at the end of 2004,  illustrating that in the past, central banks have been content to buy and largely hold the USD when it was depreciating. When it really came under downward pressure in 2004, its incremental share in reserves rose to almost 80% (Figure 2; the incremental share is the USD’s share in valuation-adjusted reserves accumulation over the prior eight quarters). A similar surge in the USD’s share occurred as it weakened into 2008. By contrast, the 2005 strength led to a much lower USD share in incremental reserves.

Yet Barclays, even as it pounds the drum on the dollar's death, attempts to retain some objectivity when highlighting the flow chart of optionality for those who run central banks yet are not blessed with Mr. Bernanke's cunning dollaricidal pathology.

While we find some evidence that central banks have a strong desire to avoid increasing the USD share, the inability of central banks to diversify out of it suggests that it is very difficult to significantly reduce the share, as well. Of course, if the USD were to drop further, its share in reserve portfolios would fall further as well, but that is hardly what is meant by reserve diversification. With about USD7,400bn in global reserves, a 1% reallocation would mean USD74bn of USD sales. That is a small number compared with gross global FX transactions, but it is more than two months of the US trade deficit. It is difficult to see how even that modest reallocation could be done without driving the USD significantly lower.

The three fears of reserve managers are: 1) losing competitiveness, which means they will keep intervening to contain their currencies’ appreciation; 2) increasing the incremental USD share in their portfolios, which means they are aggressively opportunistic in selling the USD when the private sector is buying, and more aggressive in diversification at the margin; and 3) precipitating a USD collapse, which means they are unable to push diversification to anywhere near the degree they desire.

The dilemma likely will worsen over time. As reserve portfolios grow, the potential losses from dollar weakness will mount. Moreover, diversification efforts may become riskier because the volume of USD selling required to achieve the desired reweighting of reserve portfolios is growing. From a reserve manager’s perspective, it is hard to see any benefit from a USD collapse – and, potentially, quite a bit of damage. A steep fall in the USD would simply lower the value of reserve portfolios, while any backing up of US risk premia would probably be reflected in global, as well as US, rates. This seems to argue more for caution, rather than any sudden USD move, contrary to what many FX investors fear. So while we expect USD weakness in coming months, we see more risk of a relatively low volatility grind than of a precipitous collapse.

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