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Euro and gold look better to central banks for reserves

Section: Daily Dispatches

By Paul Hannon
Dow Jones Newswires
Sunday, February 25, 2007

LONDON -- The euro made small gains as a reserve currency at the expense of the U.S. dollar in the final months of 2006, while gold is set to make a comeback as a reserve asset, a survey by Central Banking Publications showed Monday.

Although respondents to the confidential survey don't appear to have included the People's Bank of China or the Bank of Japan -- which hold the world's largest foreign exchange reserves -- they do account for 30% of total reserves held worldwide, or $1.5 trillion, CBP said. Of the 47 central banks that responded by December to the survey, 21 of them, managing reservesof $630 billion, said they had increased the share of their reserves held as euros, and 15 of thosesaid they had done so at the expense of the dollar.

The survey by CBP, a publishing company specializing in reporting on central banks and other aspects of international finance, showed that seven central banks said they had cut the share of reserves held in euros.

Nineteen central banks said they had cut the share of reserves held as dollars, while only 10 had increased the share of reserves held in the U.S. currency. Only five of the latter group, with reserves totaling $70 billion, said they had done so at the expense of the euro.

"Many respondents raised the proportion of their portfolios held in euros, in most cases at the expense of the dollar," Central Banking Publications said.

Nine central banks raised the pound's allocation, while four cut its share of reserves. Four central banks reported cutting their allocations of the Swiss franc, and none reported increasing its share.

Six central banks said they had raised their yen allocations, while four cut their allocations to the Japanese currency.

The shift into euros on the scale suggested by the survey would still leave the dollar as the dominant reserve currency by a large margin.

The International Monetary Fund has said that in the third quarter of 2006 the dollar accounted for 66% of foreign currency reserves, while the euro accounted for 25%. In the second quarter, the dollar accounted for 65% of reserves, and the euro 25.5%.

The survey also indicates that the pound continues to be the third most important reserve currency, with the Japanese yen remaining in fourth place.

After a long decline as a reserve asset, the survey indicates that gold may be about to make a comeback. Some 63% of central banks said gold had become more attractive following recent price rises and an increase in market liquidity.

But gold's role as a safe haven in the wake of natural or man-made disasters is also part of its attraction for central bankers.

"Ongoing geopolitical risks involving the U.S. and its war on terrorism make U.S. Treasurys less attractive and gold more attractive," the survey quoted a reserve manager at a developing country's central bank as saying.

Central banks have been diversifying their investment portfolios away from holdings of U.S. Treasury bonds and other low-yielding assets in recent years.

The survey found many would like to be able to invest in equities, something only three of the central banks in the survey are allowed to do at present.

Some 56% of respondents said there is a case for allowing central banks to invest in equities, although few of those came from developing economies.

However, a move into equities is unlikely to happen soon, since central banks continue to be conservative in their investment decisions.

The survey showed that in 2006, 70% didn't raise the proportion of their portfolio that is invested in "new asset classes" -- essentially, anything that isn't a triple-A rated government bond -- while 5% had cut their allocation to new assets.

Central banks were in agreement that the sharp rise in official foreign exchange reserves that has taken place in the last three years is likely to continue.

One central bank expects reserves to double over the next three to four years, but most respondents expected reserves to increase by between 20% and 59%, on top of the 70% increase since 2004.

Central banks said the greatest threat to the value of their reserves over the coming 12 months is the risk of a slowdown in a major economy -- particularly the U.S. -- and global imbalances. That contrasts with 2006 and 2005, when their greatest concern was rising interest rates.

Reserve managers are also increasingly worried by the threat posed by heightened geopolitical risks, while some also expressed concern about the growing role played by hedge funds in global financial markets.

"Hedge funds have been growing rapidly and taking huge positions in different markets, and it seems that lessons from the past are not being taken into account," said one reserve manager. "When they come to unwind their positions, the impact on the markets may be severely destabilizing."

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