Rising dollar may prompt central bank selling

LONDON (Reuters) - If the dollar's decline is over and about to give way to a prolonged upswing, there will be one group of hugely influential foreign exchange market participants unlikely to jump on the bandwagon: central banks.

Much has been made during the dollar's seven-year fall of central banks' management of their reserves portfolios, which now total several trillion dollars, and their supposed dumping of dollars for euros and other currencies.

The flipside of that logic would contend that as the dollar rises, so central banks buy more of them, right?

Not quite. Central banks tend to buy more dollars to maintain reserves portfolio balances when the greenback is depreciating and less when it's appreciating.

Also, central banks keeping their currencies pegged to or closely tracking the dollar -- policies that fueled an explosion of global reserves during the greenback's multi-year decline -- may now need to sell dollars to maintain status quo.

A close analysis of the International Monetary Fund data on global currency reserves backs this up.

Simply put, the diversification out of dollars in recent years has been exaggerated. And any dollar recovery may actually prompt central banks to increase dollar sales.

Brad Setser, Fellow, Geoeconomics at the Council on Foreign Relations in New York and who follows central bank reserves closely, is not convinced of the dollar's long-term recovery.

But he is sure central banks will keep the dollar share of their reserves broadly steady.

"There's a lot less evidence of broad-based diversification out of the dollar (in recent years) than many think," he said.

"As the dollar comes back up ... some countries that refrained from buying euros because they didn't want to buy at a bad price, they might come back to the market."

COFER IT

For example, if central bank 'X' wants to keep 60 percent of reserves in dollars and the U.S. unit appreciates 10 percent, the valuation of the bank's dollar reserves also rises 10 percent. So, to keep the ratio constant it will sell dollars.

Thomas Stolper, senior currency strategist at Goldman Sachs in London, believes the dollar is now entering a multi-year upswing phase. But he agrees with Setser on his main point.

"If FX reserve managers continue to behave as they have in the last five years, when judged by IMF data, they would sell dollars and buy euros to offset the valuation losses in the euro holdings," Stolper said.

"If they decided to do nothing they would simply grow the share of dollar reserves."

Getting anything resembling a clear picture of central banks' reserves management is a near-impossible task. They are under no obligation to divulge the currency breakdown of their reserves. Indeed, many of those with the biggest stash of reserves, like Asian and oil-producing nations, simply don't.

The best place to look, however, is the IMF's Composition of Official Foreign Exchange Reserves (Cofer).

Total reserves at the end of the second quarter this year stood at $6.87 trillion. That's more than double the $3.29 trillion from four years ago and more than four times the $1.61 trillion at the end of the first quarter in 1999.

The currency composition of $4.32 trillion of current reserves is known, with some 63 percent in dollars and 27 percent in euros. That compares to 73 percent and 23 percent, respectively, four years ago.

But that shift is almost entirely due to the explosion in growth over that period of reserves held by "developing" countries, namely Asian countries like China and oil exporters.

Their reserves now total a whopping $5.3 trillion compared with $2 trillion four years ago. The dollar share of their reserves where the currency breakdown is known has held steady around 60 percent over the past four years.

In the same period, reserves held by industrial nations have risen only gradually to $1.57 trillion from $1.28 trillion. Japan holds over $1 trillion of that, overwhelmingly in dollars.

These trends have had two main consequences.

First, it has meant the dollar share of all reserves has fallen as emerging market nations' stash has rocketed.

Second, it has meant central banks have indeed bought more of currencies like euros, sterling and yen but largely because the vast majority of their trade surpluses is in dollars. So, they have more greenbacks to exchange.

MADE OF BRIC

Effectively, as surpluses grow in countries with currencies linked to dollar, these central banks have bought more dollars to maintain the balance of reserves portfolios but have also upped their purchases of other currencies.

But in an environment of a strengthening dollar and shrinking surpluses, so the need to buy dollars diminishes. This is particularly true of oil-exporting nations, which have seen crude oil prices slump more than $40 from just shy of $150 a barrel only a few weeks ago.

"The lower price of oil will slow the incoming revenue. But this will likely reduce the amount of euros they are purchasing to keep the allocation at desirable levels," said Marc Chandler, head of currency strategy at Brown Brothers Harriman.

Recent activity from a variety of central banks shows this diminishing appetite to build up dollar reserves.

Korea has sold more than $30 billion of its reserves this year to try and prevent the won from weakening too much and fueling inflation, bringing reserves down from a record $264 billion to the lowest in over a year.

Reserves of emerging market giants Brazil and India, which total half a trillion dollars, have barely budged since March.

Even China, the gorilla in the FX reserves room, saw its reserves grow by only $11 billion in June. That was an increase of 0.66 percent on the month, the slowest rate in over seven years, notwithstanding an anomalous fall in December 2003.