Currency reserves shift least of greenback's worries

By Steven C. Johnson - Analysis

NEW YORK (Reuters) - While there is no shortage of factors stacked against the U.S. dollar these days, a sudden rush by central banks to dump U.S. assets probably is not one of them.

Still, with confidence in the greenback at a record low, it doesn't take much to turn a steady slide into a rout.

On Wednesday, the spark came from Chinese lawmaker Cheng Siwei, who said China should shift part of its $1.4 trillion in foreign exchange reserves toward stronger currencies.

Currency investors reacted by selling the U.S. dollar against most currencies, sending it to an all-time low against the euro.

For many, it marked what BMO Capital Markets FX strategist Andy Busch called "the clarion call for all currency reserve managers around the world that the largest holder of dollars is seriously thinking about selling them for other currencies."

But other analysts said a big shift in China's reserves was unlikely, as an over-hasty dumping of dollars would frustrate attempts to keep the yuan from rising too quickly and upset China's export-led growth.

What's more, given the massive size of China's reserves, such a shift would accelerate a U.S. dollar decline that's gathered steam since the Federal Reserve began cutting interest rates in September to shield the economy from this year's housing market slump and the summer's credit market crises.

That would be bad news for China, as the further the dollar slides, the bigger the chunk it takes out of Beijing's dollar-heavy portfolio of assets.

"China will not drive a run on the dollar, not now and not ever," said David Gilmore, partner at Foreign Exchange Analytics, an advisory firm in Essex, Connecticut.

SLOW AND STEADY DOES IT

That is not to say central banks' reserve allocation will remain static. In fact, most economists see scope for modest gains in the yuan, which has already risen some 5.0 percent against the dollar in 2007 and about 9.0 percent since July 2005.

The key is timing: a rapid appreciation would disrupt its export-driven growth by making Chinese products too costly in overseas markets.

"Nobody wants this to happen too quickly. The debate is no longer: will the dollar go down. It's how fast," said Jerome Booth, head of research at Ashmore Investment Management, which manages some $27 billion in emerging market assets.

But on the margins, Booth said central banks are expanding their horizons to the euro and beyond.

"The obvious thing is putting money into euros, but it's not as if one can move all his dollars into euros," he said. "You have to start moving into renminbi and rubles and rials, too."

He said some 10 percent of the money Ashmore manages comes from central banks or state-run wealth funds designed to invest part of a country's reserves for long-term gain.

Against that backdrop, investors tend to get nervous when they hear comments like those uttered by Xu Jian, a People's Bank of China official, who at the same conference as Cheng said the dollar "is losing its status as the world currency."

But according to data from the International Monetary Fund, central banks continue to add dollars to their reserves every quarter. They're adding euros, too, but the dollar share has remained fairly steady at around 65 percent.

Marc Chandler, senior currency strategist at Brown Brothers Harriman in New York, said this reflects the superior depth and liquidity of the U.S. capital market.

According to data from the Bank of International Settlements, the value of outstanding U.S. government and corporate debt through March was $23.4 trillion, more than double the eurozone's $11.3 trillion.

And while recent U.S. Treasury data showed China has reduced its holdings of Treasuries in recent months, Chandler said much of that money was finding its way into other dollar-denominated assets such as agency debt and equities.

"Foreign central banks hold more dollars today than they did a year ago, and they held more dollars a year ago than they did two years ago," Chandler said.

While the dollar is likely to decline further on the view that the Fed will cut rates again, Chandler said markets could be in for a rebound in early 2008.

He summed up Wednesday's sell-off on diversification fears as "currency investors not letting the facts get in the way of a good story."