NYTimes: Central banks tiptoeing away from the dollar

By Jeremy W. Peters
The New York Times
Tuesday, January 2, 2006

http://www.nytimes.com/2007/01/02/business/02cnd-dollar.html

Countries with large holdings of dollars in their foreign-exchange reserves are showing a new willingness to dump the dollar in favor of the rising euro.

The latest to make a major move is the United Arab Emirates, which joined Russia, Switzerland, Venezuela, and others late last month when it shifted a chunk of its reserves into euros.

There have also been ambiguous signals from China about a possible pullback from the dollar, and recent word from Iran, the world’s fourth largest oil producer, that it would prefer to be paid in euros rather than the usual dollars for its oil shipments.

Still, currency experts say these moves are not likely to do any long-term damage to the dollar, for a number of reasons.

First, the central banks that are adding other currencies to their reserves do not appear to be driven by a belief that the euro will eventually supplant the dollar as the world’s key currency. Rather, they are doing what investors typically do to minimize risk: diversifying their portfolios.

Moreover, the amounts moved so far have been relatively small in a global market that trades trillions of dollars a day -- only about $2 billion in the case of the United Arab Emirates, for example.

“There is some indication that central banks are moving to diversify reserves, but it’s at a very slow pace,” said David Powell, a currency analyst with IDEAglobal. “Is it the start of a massive shift out of the dollar? I would say no.”

Moreover, experts say that the impact of such moves by central banks is generally fleeting at best.

“Most people think it does not influence exchange rates for any long period of time,” said Edwin M. Truman, a senior fellow at the Petersen Institute for International Economics, who served for more than two decades as the director of international finance for the Federal Reserve. “It has some day-to-day effects but not any big effects.”

News of the United Arab Emirates' decision contributed to the dollar’s fall against the euro, the British pound and the Japanese yen last week. For all of 2006, the euro appreciated more than 11 percent against the dollar and the British pound rose nearly 14 percent.

But those trends seem to be driven by other forces, including varying prospects for growth around the world and changes in interest rates in the United States and elsewhere.

One reason that dollars are not likely to start pouring rapidly out of central bank vaults is that foreign countries risk devaluing their dollar-denominated investments, at least for a while, if they dump the currency. Even a slight suggestion that a central bank is thinking about swapping dollars for euros can push the dollar down in the spot markets, and in turn hurt all foreign investors in American securities.

China, which holds more Treasury securities than any other foreign nation except Japan, offers an example. In October, the most recent month for which figures are available from the Treasury Department, China held $345 billion in Treasury securities. That was up from $301 billion a year earlier. Its currency reserves total $1 trillion, about $700 billion of it in dollars, economists estimate.

So in many ways, it is in China’s best interest not to let the dollar’s value slip. Heavy sales of the dollar could make it harder for the People’s Bank of China to manage its gradual appreciation of the yuan against the dollar. Anything more abrupt, Beijing fears, would make Chinese goods less competitive in the United States and pose problems domestically for some of its state banks, limiting their ability to borrow.

Nonetheless, the rising euro is not something the United States or foreign investors can afford to ignore.

“You have to start to thinking that the euro can be of some risk to the dollar,” said Shaun Osbourne, chief currency strategist at TD Securities in Toronto. “Over the course of the next 5 or 10 years, I don’t think there’s any danger that the dollar’s pre-eminence is threatened. But in the long run, there is certainly the risk that does happen.”

One major issue driving investors away from the dollar is the possibility that interest rates in the United States and Europe may move farther apart next year.

The financial markets are currently expecting at least one interest-rate cut by the Federal Reserve sometime next year. That contrasts with predictions of further interest-rate increases by the European Central Bank. Because returns typically rise with interest rates, the euro seems like a more attractive investment.

“A lot of foreign investors think the Fed is going to cut rates in 2007, and that’s a rather dollar-bearish thing,” said Julia Coronado, senior economist with Barclay’s Capital.

Some economists predict the dollar will fall even more in 2007. The euro finished 2006 at $1.31, and some forecasters expect it to climb near $1.40, a level it has never reached in its seven-year history.

“We believe that the dollar’s decline versus the euro has further to run, with $1.38 a possible destination for the pair over the next six months,” said Tom Levinson, a foreign exchange strategist with ING Wholesale Banking in London.

Even so, few economists think the dollar is headed for an inevitable demise.

“The dollar is still the world’s No. 1 currency, and it’s going to stay that way,” said Nigel Gault, chief United States economist for Global Insight. “The euro is gradually going to become more important, but I don’t see it becoming more important than the dollar.”

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