David Morgan: The Silver Users Association is ''managing'' the price of silver

Section:

Perhaps this means that the central banks
did more propping up of the dollar because
the ordinary markets wouldn't....

* * *

Market Insight: Reserve diversification and the dollar

By Chris Flood
Financial Times, London
Wednesday, October 26, 2005

http://news.ft.com/cms/s/f00bbfac-463e-11da-8880-00000e2511c8.html

Talk of central banks diversifying their $4,000 billion foreign
exchange reserves away from the dollar is a constant refrain of
currency markets. Is it actually happening?

The dollar's share of reserves rose last year, surprising many in
the market who believed that central banks would de-emphasise the
dollar's role in their portfolio, amid concern about risks to its
value in the face of the massive US trade and fiscal deficits.

According to the International Monetary Fund, dollar-denominated
reserves accounted for 65.9 per cent of the total in 2004 while euro
reserves made up 24.9 per cent and yen reserves amounted to only 3.9
per cent.

The IMF calculates the value of reserves using end-year exchange
rates but this obscures the volume of dollar buying due to price
effects as the dollar's trade weighted index depreciated by more
than six per cent in 2004.

Last year flows into the dollar accounted for 78.3 per cent of the
increase in the quantity of reserves while the euro's share was just
13 per cent and sterling at 6.9 per cent oustripped yen flows of
just 2.2 per cent.

Weak flows into euro or yen denominated assets are explained by the
significantly lower yields these currencies offer compared with the
US.

Adrian Foster, head of foreign exchange strategy at Dresdner
Kleinwort Wasserstein, argues Asian central banks decided to support
the dollar in late 2004, recognising its importance to the region's
financial system and in pursuit of a strategy to maintain economic
competitiveness and export strength. According to Foster, now that
the widespread fears of dollar crisis have faded, large dollar
holders have been diversifying their portfolios to move closer to an
objective benchmark weighting, often in periods when the dollar
reaches cyclical highs.

While the IMF's figures show the dollar clearly retains its position
as reserve currency of first choice, there is a growing challenge to
its pre-eminence from other currencies.

A significant number of central banks has committed to diversifying
reserve portfolios to avoid concentration risk and to search for
higher returns; a shift which could have important repercussions for
the dollar and the smooth running of the global financial system.

However, the euro and the yen had a disappointing share of the
increase in foreign exchange reserves last year as central banks
added non-core currencies such as the Canadian and Australian dollar
to their portfolios to boost yields.

The Canadian dollar is one of the year's best-performing currencies,
gaining an 14-year high against the dollar with central bank buying
reinforcing support for the currency, known as the loonie, from high
natural gas and oil prices.

Other currencies, such as the Norwegian krone, Swedish krona, and
New Zealand dollar, have also attracted central banks' attention.
Mansoor Mohiuddin of UBS says: "It is only a matter of time before
foreign exchange reserves will be held in emerging market currencies
as well." He points out that a $2 billion Asian bond fund has been
set up to invest in less developed Asian markets by 11 larger Asians
including Japan, China, and Australia.

Country credit ratings for emerging economies vary significantly.
UBS believes central banks would be unlikely to invest in any
currency whose country rating was less than single A, potentially
ruling out Mexico, Brazil, Indonesia, Thailand and Turkey.

China stands out as the country likely to have the largest foreign
exchange reserves in the future, forecast to top $1,000 billion in
2007 -- according to Fitch, the ratings agency -- as its capital
account is liberalised allowing greater access for foreign capital,
China does not provide currency composition information its 20 per
cent of global reserves.

That leaves a huge hole in IMF data as 32.6 per cent of total
official reserve holdings are reported without currency composition
details. As China operated a dollar peg for more than 10 years,
analysts estimate a large portion of its reserves (about 80 per
cent) is in dollars.

A recent report sponsored by the People's Bank of China-backed
Financial News suggested Chinese reserves should shift from dollar-
denominated assets in favour of investments in other currencies. It
also said China should spend some of its reserves on strategic
resources, such as petroleum and mineral products.

Stephen Jen of Morgan Stanley says: "Reserve diversification [has
two dimensions]: across currencies, as well as across assets within
each currency." So a move up the risk curve is also occurring, with
central banks showing increased appetite for credit products,
particularly US agency debt, mortgage-backed securities, and
corporate bonds.

Diversification into riskier assets could still benefit the US as
dollar-denominated asset markets are broader and deeper than those
of the eurozone and other regions.

Mr Jen expects central banks to consider splitting their reserves
into liquity and investment tranches to manage currency shifts and
increase returns respectively.

The RBS Reserve Management Trends 2005 study conducted by Central
Banking Publications shows three-quarters of 65 central banks
(holding around 45 per cent of global currency reserves) it surveyed
have also introduced new asset classes to their investment processes
as part of a shift towards accepting riskier products.

Traditionally central banks held most of their reserves in short-
dated government bonds but an increasing number are broadening the
asset classes in which they are prepared to invest.

Gold used to account for 50 per cent of reserve holdings in early
1980s but this has now shrunk to just 9 per cent. With the gold
price moving higher, raising gold allocations might be one choice
while another potentially attractive option is inflation-linked
bonds, as an unanticipated increase in inflation is the biggest risk
to capital preservation.

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