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Foreign bondholders seen undeterred by weak dollar

Section: Daily Dispatches

By Lucia Mutikani
Friday, May 11, 2007

NEW YORK -- Foreign appetite for U.S. Treasuries is unlikely to wane despite the dollar's slump, thanks to China's slow pace of currency reforms and a large pool of petrodollars that need to be recycled.

The dollar's accelerated pace of decline against major currencies has sparked fears that foreigners may scale back their holdings of assets such as U.S. government bonds to avoid losses when they convert proceeds into their local currencies.

But analysts say given that the dollar remains the first choice for global transaction currency and reserve assets, foreign holders of U.S. securities are unlikely to rush for the exit.

The Federal Reserve's trade-weighted dollar index is down 3 percent so far in 2007, with the bulk of the decline occurring in April.

"We have not seen any significant change. What we have seen is some change in terms of private investor patterns away from bonds into stocks, but this is really at the margin," said Michael Woolfolk, Bank of New York senior currency strategist.

Woolfolk attributes the strong demand for Treasuries to the huge pools of excess savings in the oil-exporting Middle East and Asia, particularly China, which has accumulated dollars to keep its currency from appreciating.

These reserves are invested in U.S. Treasuries, a factor that has contributed to yields being lower than the official benchmark interest rate.

China, which has world's largest foreign exchange reserves at $1.2 trillion, has been criticized for the slow pace of its currency reforms.

It has announced an investment fund agency to manage about $200 billion of its assets and increase returns by investing in a wider array of financial instruments, which has raised questions whether it will remain a big U.S. Treasuries holder.

China is the second largest holder of U.S. government bonds after Japan.

Analysts point out that foreign holdings of Treasuries doubled to just over $2 trillion between 2002 and 2006, despite the dollar's weakness during that period.

"The dollar has fallen for four of the past five calendar years, through the end of 2006, yet foreign buying during that period was quite strong," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co. in New York.

Foreigners stepped up their purchases of U.S. government bonds up to February this year, latest official data show. Data for March will be released next week.

Although foreigners generally appear to be unperturbed by the dollar's depreciation, its sharp fall in April may have worried some investors, who are wary of a rapid and disorderly decline. The weighted dollar index fell 2 percent in April.

"That's the risk. That (fall) is a bit more rapid than it has been falling. We will see with next week's (Treasury holdings) data whether that was enough to turn investors back," said Crescenzi.

He says the dollar has depreciated roughly 26 percent between 2002 and 2006, which would translate to an average of roughly 5 percent every year and about half a percent a month. In that period, the amount of Treasuries held by foreigners doubled, according to Treasury Department data.

"I would call 2 percent a large decline and if it persisted then there would probably be an impact on foreign purchases," said Crescenzi.

"When there is a movement like that it becomes difficult to hedge against positions held in dollars. ... Those investors would have to worry about the loss of money they would have to incur by holding dollars and having to convert those dollars into their domestic currency in the future."

However, even if the dollar's depreciation accelerates, Treasuries could still remain attractive to foreigners due to the large current account deficit run by the United States.

This shortfall means dollars flow out of the country but are reinvested in Treasuries later by international trade partners of the United States, analysts say.

"We buy more goods than we export overseas. Dollars are going to these countries that export to us. They tend to stay overseas and get reinvested in U.S. securities," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

Foreigners "will have to stay put or find new avenues of investment because the trade imbalance means more dollars will continue to go out there," he said. "There are just too many dollars out there."

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