Global foreign exchange reserves have doubled from $2 trillion to $4 trillion in the last five years, according to investment bank UBS, with the majority of the increase going into US dollars. The currency has risen more than 10 percent against the Japanese yen and the euro in 2005 to two-year highs.
Yet there are already signs the dollar is losing some of its pre-eminence, with developing countries in particular more willing to diversify their foreign exchange reserves.
US dollar holdings of developing countries fell below 60 percent of all holdings in 2004, UBS said, citing the IMF Annual Report.
Since a 1 percent shift in reserves away from the dollar will result in the sale of some $40 billion, analysts are carefully scrutinising data for evidence on which countries may decide to diversify and by how much.
"One of the cardinal rules of financial markets is that a lack of diversification is often tantamount to ensuring financial failure," said Anthony Chan, Columbus, Ohio-based managing director & senior economist with J.P. Morgan Asset Management.
Although the evidence is scarce that central banks have diversified in force to ensure the security of their reserves, it is only a matter of time, Chan said.
Then "we will see that the effects of stronger US growth and positive interest rate differentials may be unable to offset the negative effects of such diversification in the wake of another negative fundamental trend, namely a growing US current account deficit," said Chan.
The US Federal Reserve has boosted interest rates from a low of 1 percent since June, 2004 and is expected to continue to raise official rates from the current 4 percent.
The initial fear had been that industrialised countries such as Japan, the largest holder of foreign exchange reserves, with $830 billion, would begin to diversify. But events may have already overtaken that concern.
Developing countries, whose foreign exchange reserves have exploded in recent years, are more likely to diversify their assets and potentially could have just as much impact on exchange markets, analysts say.
China's reserves increased by 87 percent to $752 billion from December 2003 to August 2005, according to national central bank data compiled by Reuters. That ranks second only to Japan, and means any move by the Chinese to diversify current holdings is bound to affect the dollar.
Some developing countries are publicly moving away from the dollar. "Russia recently said that its reserves were 60 percent in dollars, 33 percent in euros and 7 percent in sterling," Mansoor Mohi-uddin, London-based currency strategist for UBS, said in a research note. Russia's central bank held $112 billion in reserves in August, according to Reuters data.
WHAT'S PROMPTING THE SHIFT?
Central banks have historically held reserves to facilitate trade payments, meet external debt obligations and to defend any currency regime they may be following.
But the sudden rise in reserves of the last five years has prompted central banks to manage their excess reserves more actively to increase the return for reserves in excess of the minimum required for routine obligations.
That helps explain why central bank diversification has already moved beyond the euro, yen and sterling, purchased primarily for their liquidity, to the Australian and Canadian dollars.
Demand for Canadian dollars to be held as central bank reserves has fuelled some of the currency's strong performance in 2005, said UBS' Mansoor Mohi-uddin. The US dollar is down 1.3 percent against the loonie this year, compared with a 15 percent gain against the yen and the euro's 13 percent drop against the dollar. But moves to hold the Australian and Canadian dollars may be just the beginning.
UBS believes central banks' search for yield is prompting them to diversify further, into Swiss francs, Swedish and Norwegian crowns and the New Zealand dollar. Even emerging market currencies such as the Polish Zloty, South African Rand, Hungarian forint, Czech crown and South Korean won are gaining favour. While the dollar's advance is not over, it is going to have a tougher time.