Reserve managers trapped in US dollars, says Citi
Global reserve managers are caught in a cycle of buying US dollars when they should be diversifying their currency holdings, leaving them exposed to global macro and sovereign debt risk, say FX strategists at Citi.
In a note published today, strategists Steven Englander and Andrew Cox estimate that global reserves have swelled by more than two-thirds since 2007 to close to $10 trillion. About 90% is held in the G3 currencies of dollar, euro and yen. The US dollar is the biggest single component, making up about 65% of total reserves, the strategists estimate.
Englander and Cox suspect that reserve managers consider their holdings in G3 currencies to be of dubious quality, but diversifying – in particular from the US dollar – isn’t viable because managers aren’t prepared to take the losses on their portfolios.
“The issue is whether or not reserves managers are willing to absorb the valuation hit from selling the US dollars that they would like to sell. The answer is, by and large, no,” write Englander and Cox.
That’s probably because reserve managers’ US dollar portfolios are too big relative to the size of the market, the strategists claim. They argue that even if managers tried to diversify 10% of their dollar holdings into other currencies, the market would have difficulty absorbing it, even if spread over a couple of years.
Still, the pair argue that there are some alternatives. Reserve managers should try hard to diversify out of the G3 and use pullbacks in smaller G10 currencies as an opportunity to buy. Another method to slow inflows could be allowing emerging-market currencies to appreciate more, or possibly buy US dollar-denominated assets that are inversely related to the performance of the dollar, such as US exporters.
Englander and Cox conclude that the alternatives aren’t particularly attractive because the non-US dollar asset pool isn’t that deep.