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Foreign Exchange

Reserve management: Reserve judgement on dollar diversification

With the US apparently nearing the end of its rate cycle, attention has started to focus again on the possibility of global central banks selling dollars and diversifying their reserves. But has the story has been overstated?

According to Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi UFJ, there is strong evidence to suggest that the importance of reserve diversification by the world’s central banks has been overstated.

Halpenny feels that the end of the cycle of interest rate increases in the US has caused market participants to search for what will be the next driver of the dollar’s value. “The market is starting to look at how the US will fund its current account deficit,” he says. “The perception that emerged at the end of the fourth quarter of 2004 was that the US would look to weaken the dollar to do this and that would fuel diversification.” The Bank of Italy’s move at the start of August to decrease its dollar holdings in favour of sterling seems to provide evidence that this perception is correct.

However, although past data are clearly no predictor of future patterns, Halpenny says they show that there has only been limited diversification away from the dollar. And as this has occurred over a period when the dollar has weakened, he questions whether there is any reason to believe it will now pick up when some of the strong dollar negatives appear to be waning in power.

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