Dollar Off on Talk of Shift in Reserves

Talk is rising again about central banks in key emerging economies shifting some of their largely dollar-dominated currency reserves into euros or other currencies. That is driving up the euro’s value against the greenback.

The euro jumped to $1.226 on Tuesday from $1.214 on Monday as comments from China, Qatar and Kuwait highlighted the desire of reserve managers to enhance returns on and diversify their huge investment portfolios.

Some analysts, however, say the threat against the dollar may be exaggerated. The Federal Reserve’s 15 interest rate hikes since June 2004 have taken the benchmark short-term U.S. rate to 4.75% from a historic low of 1% in 2003, making the ditching of dollars less attractive as far as yield is concerned.

“The story of central banks shifting out of dollars has been a problem for the dollar. But the Fed has been aggressive and U.S. interest rates are rapidly going up. So the cost is getting high to shift out of dollars,” said Johan Javeus, a currency strategist at investment firm SEB in Stockholm.

Speculation about diversification of central bank reserves was partly behind the dollar’s fall from 2002 to 2004, which took it to record lows against the euro.

Central banks worldwide hold more than $4 trillion in reserves. Asia and Russia hold more than 70% of the total. Their currency reserves have ballooned as their economies -- and trade surpluses -- have boomed.

Talk of central bank diversification intensified Tuesday after Cheng Siwei, a vice chief of China’s national parliament, said China should trim its holdings of U.S. debt and could stop buying dollar-denominated bonds. China’s central bank later said Cheng was expressing his personal views.

Separately, Qatar’s central bank governor Abdullah bin Khaled al Attiyah said the bank might want to hold as much as 40% of its reserves in euros. As of mid-2005 it held more than 90% in dollars.

Kuwait’s central bank governor, Sheikh Salem Abdul-Aziz al Sabah, said the bank was studying whether the euro was becoming more attractive as a reserve currency.

The dollar’s share of global foreign-exchange reserves stabilized at 66% in 2004 after falling from a 1999 peak above 70%, according to the International Monetary Fund.

By contrast, the dollar’s typical share of diversified portfolios overseen by private global fixed-income managers is about 50%.

“If they [central banks] move close to private-sector benchmarks, the dollar’s share is likely to fall,” said Michael Metcalfe, senior strategist at State Street.

Analysts say an escalation in diversification talk, along with any signal from the Federal Reserve that its credit-tightening campaign is nearing an end, would damage the dollar.

“Heightened market attention to [the diversification] theme shows the extent to which the structural concerns which plagued the dollar in 2003 and 2004 are back in play, now that the Fed [rate-increase] cycle is drawing to a close,” brokerage UBS said in a note to clients.