Central Banks Continue to Reduce Their Share of Dollar Reserves

Numbers newly reported from the IMF’s COFER data base show that in the most recent quarter, the spring of 2009, the share of central banks’ foreign exchange reserve holdings that they allocate to dollars resumed its downward trend. The dollar share has been gradually sliding since the beginning of the decade – perhaps because of the birth of a possible rival, the euro, in 1999, or perhaps because of the long-term path of tremendous fiscal and monetary expansion on which the United States embarked in 2001.

During the four quarters preceding the most recent one, the share of the aggregate portfolio that the world’s central banks allocated to dollars had temporarily reversed direction. Arithmetically, the main source of this increase in the dollar’s share was its appreciation against other currencies. But another source was the action of central banks in industrialized countries, acquiring dollars more rapidly than other currencies. The movement of the raw quantity shares can be seen in the first graph below, and the movement in the shares properly valued at current exchange rates in the second graph. (I am grateful to Ted Truman and Dan Xie, both of the Petersen Institute for International Economics, for these graphs.)

Whether the temporary reversal from Q2 of 2007 to Q1 of 2008 is measured in quantity terms or in valuation terms, the phenomenon was presumably a (surprisingly strong) safe-haven reaction to the global financial crisis. Apparently the recent easing of risk and liquidity concerns has mitigated the flight into dollars. The central banks that had shifted into dollars have now begun to shift back a bit, into euros in particular.

The gradual downward trend of the dollar’s share during the past decade is a continuation of the trend that began the end of the Bretton Woods system: from the late 1970s until 1991. The dollar’s share rose from 1992 to 2000, perhaps because of the deficit reduction path that began with George H.W. Bush’s unpopular fiscal reversal and continued throughout Bill Clinton’s presidency, until George W. Bush took office and reinstated the chronic deficit.

The usual response to worries that US macroeconomic profligacy will eventually end the dollar’s privileged position as lead international currency has always been that no asset constitutes a credible alternative for central banks to hold in their portfolios. I have argued that, since 1999, the euro has constituted a credible alternative. Based on econometric estimates of the determinants of central banks’ reserve holdings in research with Menzie Chinn, we have even gone so far as to report simulations that show the euro overtaking the dollar by 2022. Many, like Ted Truman, consider such speculation exaggerated. They may be right.

But the euro is not the only alternative to the dollar. The yen, pound and Swiss franc remain viable alternatives for national authorities to put some of their reserves. Furthermore, 2009 has seen the resurrection of two international reserve assets that had previously been written off as dead: the SDR and gold. My forecast is that we are gradually moving from the dollar standard to a global monetary system that features multiple reserve assets.

Share of central banks foreign exchange reserves allocated to dollars, 1999 QI – 2009 QII

(among industrial countries, among developing countries, and overall)

Comments

[User 353732:]

The notion that the US dollar or US Govt and agency debt is a safe haven under the current WashDC-Wall St fiat dollar, gross self indulgence, Regime seems dangerously divorced from reality. The notion is more the product of investing inertia and nostalgia for the days when the US dollar indeed was a symbol of a global hyperpower.

Today, the barrier reefs and surge walls of wealth creation, integrity and market discipline that created the safe harbor for the dollar have been seriously eroded and are in tragic disrepair. They are crumbling by the day and the safe harbor is increasingly at the mercy of fierce and wicked policy tempests.
Safer havens may now have to sought, oddly enough in energy resources, agricultural land and in the equities of global corporations that have the reach, competence, balance sheet and management to navigate the interregnum between the dollar as sole reserve currency and whatever comes next: maybe 2 or 3 regional reserve currencies.
The US Govt -Wall St co-dominium is now the largest single source of investment and economic risk in the world and the instrument of dollar degradation. It is not the Chinese, Russians, Brazilians etc that are demoting the US dollar in global finance: its the US Govt, abetted by Wall St.

Oct 02 06:05 AM

[Living4Divi...:]

Jeffrey Frankel - I agree with the central premise of your article that the dollar is losing its status as a reserve currency.

Having said that, let me muddy the waters a bit with a question. I am wondering if the decline in Central Bank holdings is merely a mirage caused by switching reserves from official Central Bank holdings to Sovereign Wealth Fund holdings?

Question: have you considered this possibility?

Oct 02 04:55 PM

[Old Trader:]

Living4,

A good question, if I may take a shot at it? Since SWFs are funded by their respective countries, yes, their intial "stake" is in dollars, possibly, but then the funds are invested into other assets, so the next result is that Country X holds fewer dollars. At least that's how it would appear to me.


On Oct 02 04:55 PM Living4Dividends wrote:

> Jeffrey Frankel - I agree with the central premise of your article
> that the dollar is losing its status as a reserve currency.
>
> Having said that, let me muddy the waters a bit with a question.
> I am wondering if the decline in Central Bank holdings is merely
> a mirage caused by switching reserves from official Central Bank
> holdings to Sovereign Wealth Fund holdings?
>
> Question: have you considered this possibility?

Oct 02 05:44 PM

[reziemba:]

It's also worth noting the top chart - that the stock of reserves whose managers report the currency share has likewise eroded as the fastest reserve growth comes from countries like China which decline to pass on their currency composition to the IMF.

to some extent the decline in dollar share of countries that report their currency composition is in part offset by high dollar shares of those that don't and by including non-reserve savings (eg the non-reserve assets of Saudi Arabia)

But overall I agree, the role of the dollar as reserve currency is slipping even if other policies (exchange rate stability in China for one) limit diversification away from the dollar.

Actually if one looked at SWFs, you'd notice an even sharper

Oct 04 04:18 PM

[User 466224:]

Yes, I agree with the response that the others have given to the SWF question. It is indeed an interesting important phenomenon that countries like China have shifted part of what would otherwise have been a central bank portfolio into their Sovereign Wealth Funds. But the leading reason for doing that is to diversify further out of US treasury bills. While part of the diversification has been into other US assets, much of it has presumably been elsewhere. Thus the decline of the dollar's share would look worse if the data were available and one included the SWFs.

Jeff Frankel

Oct 07 10:10 AM