Mansoor Mohi-uddin: Asia will keep propping up dollar

Dollar Still Reigns Supreme

By Mansoor Mohi-uddin
Financial Times, London
Wednesday, April 15, 2009

http://www.ft.com/cms/s/0/5af1ee74-29ce-11de-9e56-00144feabdc0.html?ncli...

Asia is the last bastion of the strong dollar policy. US policymakers still repeat the mantra of a strong currency. But it is Asia's central bankers that have backed up their words with action, accumulating thousands of billions' worth of US Treasuries.

The dollar remains the world's premier currency as a result. It still accounts for nearly two-thirds of all foreign reserves. Moreover, the recycling of excess savings globally into US capital markets enabled US consumers to buy imported goods and real estate far beyond their means during the great economic boom, and also enabled the US government to run immense fiscal deficits to offset the great economic bust.

But is the dollar's bastion about to wobble? China's policymakers are now questioning whether the country should continue keeping the lion’s share of its $2,000 billion dollar reserves in American assets. Zhou Xiaochuan, governor of the People's Bank of China, has even suggested that the dollar be replaced as the world's reserve currency by the IMF's special drawing rights -- a basket of currencies that consists of the dollar, euro, yen and sterling.

The reaction in the currency markets was swift. The dollar fell immediately when Tim Geithner, Treasury secretary, was mistakenly interpreted as indicating he would consider Mr Zhou's suggestion on SDRs. The euro -- which accounts for more than 20 per cent of global reserves, the second-largest share after the dollar -- was the main beneficiary of the dollar's weakness, while gold also benefited, given its historic reserve status.

A real shift by central banks away from the dollar would have big implications for financial markets beyond exchange rates. The US Treasury market -- half of which is owned by foreign investors -- would crash if official bond holders began to desert it. The ensuing rise in long-term yields would sharply increase the costs of financing in America's mortgage and corporate bond markets. To counter the fall in the dollar and the spike in long-term interest rates, the Fed would have to consider lifting the Fed funds rate from zero, while the Treasury would need to consider reining in its fiscal deficits. That would shock equities too.

Fortunately, the risk of the dollar losing its reserve status remains slim for the foreseeable future. First, central banks are likely to keep holding most of their reserves in dollars as global trade remains denominated in dollars.

Second, the incentive for reserve managers to diversify into other foreign currencies to increase portfolio returns is mitigated by all the G7 central banks now setting interest rates close to zero.

Third, central banks across Asia and elsewhere have seen how Russia rapidly lost one third of its $600 billion reserves as the rouble came under severe pressure. Reserve managers will hoard their dollars in case their domestic currencies come under speculative attack.

Fourth, the alternatives to the dollar remain unattractive. Liquidity in the US Treasury market is superior to eurozone bond markets. Holding euro-denominated assets also incurs the long-term risk that the single currency may one day break up. As for the other choices, Japanese government bonds only offer very low returns, while the gold market is too small to be a liquid alternative for most central banks.

Finally, allocating foreign reserves is as much a political decision as an economic choice. The US's allies in Asia and the Middle East are hardly likely to dump the assets of the country whose military umbrella they shelter under.

Thus the dollar is likely to retain its premier reserve status. The disastrous consequences of overseas reserve managers fleeing US markets will act as a restraint on America's policymakers, while the risk of huge capital losses will force foreign central banks to stick with the US Treasury market. Indeed, the only real alternative to the dollar over the next three decades is not likely to be the euro, yen, gold or SDRs but, in fact, Mr Zhou's renminbi. But until China's economy, bond markets and currency regime come to respectively rival America's for size, depth, and convertibility, Asia is likely to remain a bastion for the dollar.

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The writer is managing director of foreign exchange strategy at UBS Investment Bank.

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