Rising dollar may prompt central bank selling

By Jamie McGeever - Analysis

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.