FYI | Aug 07 2006
By Chris Shaw
Last week the European Central Bank lifted its official interest rate 0.25% to 3.0% and indicated further increases were likely in coming months, with the British matching the move by also lifting official rates by 0.25%.
The immediate response was for both the Euro and the Pound Sterling to gain against the US dollar, a trend many experts such as Dennis Gartman from The Gartman Letter expect to continue in coming months, particularly as the US appears to be on the verge of pausing in its cycle of interest rate increases.
Adding fuel to the fire is news more central banks are moving to limit the amount of greenbacks that make up their holdings of foreign reserves, with the Bank of Italy the latest in a line to announce it has reduced its exposure to the US dollar. The bank has revealed it now has 63% of its foreign reserves in US dollars, down from 84% as at the end of 2004.
To a lesser extent the bank has also reduced its Yen holdings to 10% of reserves from 14% previously, with the pound being the main beneficiary. The bank now holds 24% of its reserves in pound sterling, as against no holdings in 2004. The choice of the pound was fairly easy in the bank’s view, as Britain remains the major trading partner for the "Eurozone" and there continue to be questions about the outlook for the Japanese economy.
The bank is certainly not the first to switch holdings out of the US dollar, as central banks in countries such as Sweden and Russia are among others to already have adjusted or have announced earlier this year the intention to adjust the composition of their foreign reserves.
Russia’s decision is significant as it remains one of the major holders of US dollars, with an estimated US$185bn as at the end of June, this despite moves by the bank to reduce its exposure to around 40% from more than 60% previously. This holding still pales in comparison to China and Japan though, who are estimated to hold about US$941bn and US$844bn respectively.
For both Asian giants the situation is more complex, as news they were looking to switch significant proportions of holdings out of the US dollar would likely spark a collapse in the greenback, with global implications for currencies and economic growth. As a result they have been forced to perform this switch via the purchase of real assets, the Chinese in particular doing so through the acquisition of mines and interests in natural resource projects and oil companies, a trend that seems likely to continue.
Adding weight to the trend away from the US dollar is the push for regional currencies, where the Euro was clearly the trendsetter. The Asian Development Bank has been behind the recent push to create an Asian Currency Unit, which would create a more stable alternative for investors or central banks when considering foreign currency holdings in Asia, which is unavoidable given the region’s importance as a trading zone for the rest of the world.
Gold has been another winner in the shift away from the US dollar, with the expectation this trend is likely to continue given the traditional inverse relationship between the gold price and the direction of the US dollar.
So while the Bank of Italy may not be a major player in terms of the impact of its policy moves, its announcement of a switch away from the US dollar gives further evidence the trend is strengthening, meaning all the US dollar bears may yet be proved correct, even if it has taken longer than many in the market have expected.