CENTRAL BANKS ARE NOT THE CULPRIT BEHIND A WEAKER DOLLAR / THE FINANCIAL TIMES

Central banks are not the culprit behind a weaker dollar

Falling reserve currency has loosened global financial conditions

John Plender


The Bundesbank recently declared it was proposing to move part of its reserve holdings into the renminbi © Bloomberg


Dollar weakness has been one of the hallmarks of Donald Trump’s chaotic administration, while bearish sentiment towards the greenback has been notably persistent since the turn of the year. In the short run the US government shutdown has clearly done nothing to help. At the same time the breakthrough in Germany’s coalition talks puts yet more pressure on the dollar against the euro.

What is striking about the longer-term trend is how little interest rate differentials have had to do with it. Since last summer widening interest differentials between the US and other advanced economies have failed to underpin the dollar. In effect, leading currencies have not been responding to the supposed laws of international finance. Hence growing speculation that a structural shift may be under way whereby Trump’s dollar is losing its status as the pre-eminent global reserve currency. The suggestion is that managers of official reserves are dumping it in favour of non-traditional reserve currencies including the renminbi.

There is some superficial evidence to support this hypothesis. According to David Sunner of the Reserve Bank of Australia, the share of total reserves allocated to non-traditional reserve currencies rose from 2 per cent in 2009 to almost 7 per cent in 2017. The Australian and Canadian dollar each account for about a quarter of that latest figure and are now included in two-thirds of all reserve portfolios.

At the same time the renminbi has become an alternative reserve asset to the dollar since the International Monetary Fund decided in 2016 to include it in the basket of currencies that make up the Special Drawing Right. Last week the Bank of France revealed that it held an unspecified amount of its reserves in renminbi just after the Bundesbank declared it was proposing to move part of its reserve holdings into the Chinese currency. This came after the European Central Bank’s announcement last June that it had sold a small amount of its dollar reserves to reinvest in €500m worth of renminbi.

While this may be symbolic of a shift to a multipolar reserve currency system it is nonetheless peanuts in global market terms. The dollar still accounts for close to two-thirds of all official reserves, while the renminbi is little more than 1 per cent. And the shift to non-traditional reserve currencies is best seen not as a verdict on the dollar but as central bank herding in pursuit of yield. In today’s low interest rate world the return on their precautionary holdings of highly liquid sovereign IOUs is dismal. This has been felt most conspicuously in euro sovereign debt where since mid-2014 yields across much of the market have been negative. The euro has thus been dumped in favour of the dollar and other currencies. And there has been modest diversification into emerging market sovereign debt.

A growing number of central banks have also been increasing their exposure to equities and corporate bonds. This brings diversification at the cost of liquidity and credit risk. It can also make sense for emerging market central banks whose mercantilist interventions to keep their currencies undervalued have caused reserves to balloon. With reserves far in excess of what is required to guard against a currency collapse, it makes sense to maximise returns on the non-precautionary portion of those reserves.

The case for seeing the central banks as authors of the dollar’s decline sits a little uncomfortably with the behaviour of the world’s biggest holder of foreign exchange reserves.

After a big run down in 2016 China’s reserves rose $129.5bn to $3.1tn last year. It would be surprising if none of that went into the dollar. The broader capital flows picture is also suggestive. The Institute of International Finance estimates that capital outflows from China in 2017 will amount to about $60bn following a regulatory clampdown, compared with a spectacular $640bn in 2016.

The good news for investors about dollar weakness is that it loosens global financial conditions, so equity markets are exuberant. But to assume weakness will continue could be dangerous.

The yield even on short-term US Treasuries now exceeds the yield on US equities. Given the intensity of the hunt for yield not only by official reserve managers but by investors more generally, there is a distinct possibility that global capital could re-acquire an appetite for the dollar. This is treacherous territory.