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Dollar still preferred reserve currency despite holdings drop, UBS says

The US dollar is likely to remain the preferred reserve currency for some time yet, even as the latest data on reserve holdings of foreign currencies shows a decline in global US-dollar denominated reserves, says UBS in a research report.

In the Composition of Foreign Exchange Reserves (COFER) report published by the IMF, US dollar reserves declined by 0.8% in the first quarter of 2011, while holdings of euro-denominated reserves rose by 5.1%, to $1.409 trillion at the end of March, according to the report. However, when adjusting for valuation – the euro rose from 1.3282 to 1.4190 over the quarter – total euro holdings actually fell by €6 billion, UBS analyst Geoffrey Yu estimates.

The net selling was probably due to ongoing investor concerns about the financial state of peripheral sovereigns in the region, which most notably saw the liquidation of €30 billion of reserves in the third quarter of 2010. Meanwhile, the US dollar suffered outflows, mainly due to concerns about an extension of quantitative easing, which the euro failed to benefit from, as reserve managers chose to move into other currencies.

“We doubt that the EUR benefitted materially from these flows, and we highly advise against positioning for the structural uptrend in the euro based on reserve flows,” writes Yu in the report published late last week. Meanwhile, other currencies, such as those connected with commodities, are coming into favour as alternative reserve currencies, according to Yu.

When the bank held its 17th annual reserve management seminar for sovereign institutions late last month, the biggest event of its kind according to UBS, delegates were asked what they believed would be the most important reserve currency in 25 years’ time. The majority of respondents said it would be a “portfolio of currencies”.

Meanwhile, barely 5% thought the euro would be the most important currency – lower than “an Asian currency” – and less than 30% believed the US dollar would remain pre-eminent.

“If reserve managers eventually plan on adding fiscal performance to yields and liquidity as benchmarks for investment selection, emerging-market names suddenly look rather attractive in head-to-heads with ‘traditional’ reserve currencies,” Yu concludes.

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