The Reserve Dilemma

The persistent worry about the US current account deficit has subsided and has been replaced by anxiety over the vast accumulation of central bank reserves and the risk of diversification out of dollars. This concern seems exaggerated, but it is unlikely to go away any time soon.


In recent weeks, both the Swiss and Russian central banks became the latest to announce a shift in the compositions of their official reserves away from dollars. Recently Chinese officials intimated that their reserves had reached the unprecedented level of $1 trillion. Japanese reserves are not far behind. On November 8th, Japan announced its reserves rose by $4.28 billion in October to a new record high of $885.55 billion. The risk that Japan and to a greater extent China decide to diversify the composition of their reserves weighs on dollar sentiment.

There has been persistent talk in recent days that Asian central banks have been buying euros and/or sterling and the scuttlebutt suggests this demand will be a feature going to the end of the year. Yet there is very little evidence of foreign official dollar sales. Consider that the indirect bidders, which includes foreign central banks (and other institutional investors as well) bought a greater share of the new 10-year note sold on November 9 than in any Treasury auction since February. The Federal Reserve acts as a custodian for some foreign central banks and international accounts. Its custody holdings (Treasuries and Agencies) have risen by $17 billion since the middle of September, of which $12 billion has been purchased in the last three weeks.

Recall also that the Treasury’s International Capital (TIC) report showed foreign investors purchased a net $119.5 billion of US bonds and stocks in August, a record amount. The US Treasury’s data indicates that far from selling, Chinese investors have been net buyers of US Treasuries every month since last November for a cumulative increase of $36 billion. In August, which is the latest date for which data are available (September report is released on November 16) Chinese investors owned more US Treasuries than ever ($339 billion).

The situation in Japan is less favorable. Its holdings of US Treasuries peaked in August 2004 at almost $700 billion and have trended gently lower since. As of August, Japan’s holdings of US Treasuries stood at $644.2 billion, down from $669 billion at the end of last year.

Chinese official comments have been clear. They recognize China has accumulated a vast amount of reserves that pose a certain management challenge. Officials appreciate that moves to diversify out of dollars risk undermining its remaining reserves. Chinese officials, including the PBOC Governor Zhou this week, have said that China is seeking ways to diversify the dollar component of its reserves from Treasuries to higher yielding dollar paper. Zhou suggested that he was looking at a wide range of instruments. The dollar-denominated bond market extends well beyond US Treasuries and Agencies. It includes corporations and non-US sovereigns or quasi-sovereigns.

Knowing the Knowable

The composition of the nearly $4 trillion of central bank reserves is shrouded in mystery. Major industrialized countries report the composition of their reserve holdings to the IMF. However, their share of total reserves is modest and even more so if Japan is excluded. Currency reserves are highly concentrated. Six countries: China (including Hong Kong), Japan, Taiwan, South Korea, Russia and Singapore account for more than 2/3 of the world’s currency reserves. The composition of half of the developing countries’ reserves is not reported to the IMF. This lack of information complicates discussions of the dollar’s share of reserves.

What we do know is that the dollar’s share of the reserves of the advanced industrialized countries has not changed very much. If anything, perhaps owing to the massive intervention in late 2003 and early 2004 by the BOJ, the dollar’s share may have actually increased slightly compared with the roughly 66.6% average of the 1995-2004 period. The euro is the second most important reserve currency for these countries. However, it remains smaller than the sum or its parts. This is to say that prior to the preparations for European Economic and Monetary Union (EMU), the Deutschemark, French franc, and ECU (European Currency Unit) accounted for 32.7% of industrial country’s reserves.

Of the half of the developing countries reserves for which the composition is known, there is indeed evidence of diversification away from the dollar. There has been a steady decline in the dollar’s share since peaking near 72.5% at the end of 1997. The most recent data puts the dollar’s share below 60%.

Non-Zero-Sum

Some observers seem to believe that a decline in the dollar’s share of reserves is tantamount to a divestment of dollars. But this is not necessarily the case and does not in fact appear to be the case now. As the demand for reserve assets grow, the number of dollars, euros, and British pounds (Russia and Switzerland recently acknowledged having bought yen for reserve purposes too) may all increase.

Nor does the diversification of reserves necessarily entail the sale of dollars. The Bank for International Settlements estimates that since the mid-1990s a fifth to a quarter of the official dollar-denominated reserves is held in non-US investments offshore. There are many reasons why a foreign central bank would hold dollars outside the US. A BIS paper argued that country risk factors may help explain such an investment strategy. While the US is loath to confiscate foreign assets in the United States, there are numerous cases of it freezing assets. There are also times when US courts put liens on foreign assets. In addition, foreign officials may desire to diversify their trading operations and build in some redundancies for security purposes the same way that private sector financial institutions have done.

The desire to improve returns is encouraging some central banks to adopt more active management for at least part of their reserves. Singapore has been one of the pioneers of more active reserve management. The IMF estimates that in 2003, 14-20 central banks allocated some of their reserve management to private fund managers.

What Not To Expect

It seems unreasonable to expect a central bank to pre-announce to the world its reserve allocation decision. They simply don’t do that. Consider China. It is trying to prevent speculators from profiting from the adjustment of the yuan’s value. Are we really to expect that the PBOC Governor Zhou will tell these same speculators that it is going to sell dollars, so they can sell in front of them?

It is not clear how the reserve dilemma is played out. It is not immediately obvious that there is another currency that is broad and deep enough to rival the dollar-denominated market. What about the euro market? Because of the different tax regimes, issuance schedule and modest size of any one offering, the sovereign euro-denominated bond market is more like the US municipal bond market than the deep and broad US Treasury and Agency market.

A clear and viable alternative to the US dollar would seem like a necessary condition for a true resolution of the dilemma. Perhaps how Europe has sold gold might be a useful precedent. Although the Bretton Woods System collapsed because a few European countries wanted gold rather than dollars and US President Nixon unilaterally refused by closing the gold window, a few years ago European countries decided they now had too much gold. To avoid a competitive panic, they colluded to achieve an orderly market agreement that limited the annual sales—stretched them out over the years, with little market impact net-net.

Investors should not expect a heads up from foreign central banks until after they make their adjustment. Instead of reacting to what officials say, investors concerned about the diversification of reserves out of dollars should focus on what foreign central banks are actually doing. Watch the TIC data, Federal Reserve custody holdings, and participation at US auctions to monitor the situation.