22 November 2007

Central bankers grapple with dollar conundrum

Central bankers grapple with dollar conundrum

By Peter Garnham in London

Published: November 21 2007 02:00 | Last updated: November 21 2007 02:00

The sliding dollar has presented custodians of the world's massive foreign exchange reserves with a conundrum.

Countries such as China and those in the Gulf, which peg their currencies to the dollar, risk inflationary pressure that has the potential to trigger serious economic and social problems.

But any move to cut their links to the dollar could spark a run on the currency that would undermine the value of their reserves.

Global currency reserves have soared from $2,000bn in the second quarter of 2002 to $5,700bn (€3,885bn, £2,780bn) in the corresponding period this year, according to the International Monetary Fund.

Furthermore, two-thirds of the world's reserves are in the hands of six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

But China tops the league, with the latest official figures showing the value of its reserves at $1,443.6bn in July.

Many of China's trading partners argue that this stockpile - which grew at $40bn-$50bn a month in the first half of the year - has been caused by what they believe to be an undervalued renminbi.

Most analysts say that

the country's reserves have accumulated rapidly since July and that this explains the growing concern about the dollar expressed by Chinese officials.

Yesterday the dollar plunged to a record low of $1.4813 against the euro.

Beijing does not reveal the currency composition of its reserves. However, informed observers say the weightings of its various currencies roughly follow the latest figures from the IMF.

Central banks which have revealed the make-up of their reserves hold on average 64.7 per cent in dollars, 25.5 per cent in euros and the remainder in currencies such as sterling, yen and the Australian dollar.

China's concerns have been highlighted by Wen Jiabao, the premier, who said the country had never experienced such pressure over its reserves and that he was worried about how to preserve their value.

Hans Redeker, at BNP Paribas, says these comments are a clear indication that China wants to slow down the pace of increase of its reserves.

Primarily driven by food prices, China's rising rate of inflation currently stands at 6.5 per cent. Mr Redeker suggests that a rising renminbi is now favourable for the country as it will reduce import price pressure for food products.

"The undervalued renminbi supplied the globe with excess liquidity while the investment boom created demand for raw materials," he says. "This overvaluation [of raw materials] is now going to correct as China leads its currency closer to its fair value and tighter domestic conditions slow investment spending."

While an appreciation of the renminbi would slow China's accumulation of foreign exchange reserves, it would not address the problems caused by the weak dollar undermining their value.

Simon Derrick, at Bank of New York Mellon, says it is ironic that a large part of the reason for the dollar's fall can be attributed to central bank reserve managers.

IMF data reveal that, in the second quarter of 2002, the dollar represented 71 per cent of central bank holdings, while only 19.7 per cent was held in euros.

"All the available evidence indicates that the phenomenal growth in foreign exchange reserves over the past five years has been accompanied by a notable push to diversify away from the dollar and into the euro," he says. "This explains the rise of the euro."

Other analysts were less sure of the role played by central bank reserve diversification in the dollar's fall.

They say cyclical factors are the main driver behind the dollar's 40 per cent drop against the euro since 2002, arguing that the shift in reserve currency allocations needed to drive the dollar so far would be much greater than the shifts reported by the IMF.

Marc Chandler, at Brown Brothers Harriman, says central banks may well be diversifying new reserve accumulation away from the dollar, but China's recent comments do not mean they are diversifying existing holdings. "What incentive do they have to tip their hand, even if that is what they intend to do?" he asks.

In any case, Mr Chandler believes it is unlikely that the Peoples' Bank of China has turned from the traditional role of a central bank to become a currency speculator.

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