Currencies | Nov 20 2012
By Greg Peel
The International Monetary Fund was created after World War II at which point the US dollar became the official global reserve currency. The pound sterling had up to World War I assumed that mantle. The IMF has since endowed other major currencies with reserve status, the last being the euro after its creation in 1999 which replaced major individual European currencies.
While reserve status may be a fairly technical issue which does not prevent global central banks holding reserves of which ever currency they choose, the implication is that the IMF sees reserve currencies as being sufficiently robust in terms of the size of the economy behind them, the transparency and maturity of the financial system of that economy, and the ease of convertibility of that currency. Also important is the transparency of reserves held by the central bank controlling the reserve status currency, as this to an extent represents the robustness of that currency's “asset backing”.
Up to now, IMF reserve currency status has been extended to the US dollar, the euro, sterling, yen and Swiss franc. An important step was taken in 1995 when the IMF introduced a database of “composition of foreign exchange reserves” (COFER) from willing central banks who previously had preferred to keep their sovereign assets a secret. Secrecy is still required, which is now the responsibility of the IMF. Previously publicity shy countries such as Switzerland, the UK and now even Russia are willing to provide information as long as it goes no further.
The obvious question is: what does reserve status actually imply? Perhaps the simple answer lies in the statistics. Since the introduction of COFER in 1995, world foreign exchange reserves have risen from US$1.4trn to US$10.5trn at mid-2012. Declared reserves as at 2001 included 71.5% in US dollars, but that figure has now fallen to 62%. In 2001, 1.3% of declared reserves were comprised of “other” currencies outside of the five reserve currencies. Today that figure is 5.3%. If we do the maths we can imply a 7.5% increase in non-US reserve currency holdings over a decade (euro, sterling, yen, franc). That may not sound huge but when we're talking a total of US$10.5trn that's a lot of money.
There are no Asian (ex-Japan) currencies in the IMF reserve basket. A small number of central banks hold reserves in Korean won, Singapore dollars and Chinese renminbi, for example, but not enough to justify reserve status. Beijing's ambition is to lift the renminbi to global reserve status – eventually crowding out the greenback – but a lot of financial reforms will have to be addressed before this could ever happen. At present, the renminbi is not even directly convertible into other currencies.
However, last night the IMF decided both the Australian and Canadian dollars are now worthy of reserve status, increasing the global list to seven currencies. “The popularity among central banks of the Australian and Canadian dollars, which have been relatively strong even against the firm US dollar during the past few years,” suggests the Wall Street Journal, “reflects their stable economic growth and intact banking systems since the financial crisis, as well as the influence of Australian and Canadian commodity resources. On informal estimates, worldwide official foreign exchange holdings in each of the two currencies probably are around US$60bn”.
The IMF has asked member countries to include the AUD and CAD in reserve holding statistics from next year.
The IMF has made its decision after spending 18 months attempting to firm up the viability of its COFER database, contacting 191 countries including China which do not report foreign currency reserves. Of that figure, 63 have agreed to respond to the survey. The IMF found ten other currencies outside of the five reserve currencies being held by the 63 respondents, of which the Australian and Canadian dollars, notes the WSJ, “are by far the most important”.
And we wonder why the Aussie will just never go down.
Some 40 countries provided a total figure for currency reserves but not a breakdown, which total US$4.7trn or 44.5% of the US$10.5trn total. China did not deign to participate in the survey, preferring to keep its reserve allocations, and any change in policy of allocations, to itself. However, an official Chinese publication reported in 2010 that China's reserves (which in 2012 total US$3trn) were broken down into 65% US dollars, euro, 5% sterling and 3% yen. It is expected China will increase transparency over time, but not speedily.
The Reserve Bank of Australia conducts its own survey of global central banks and at best can confirm fifteen banks hold Aussie dollars in their reserves while another eight probably do. Some countries, including Finland, Brazil and Switzerland offer up their own public information on Aussie holdings which total around US$40bn. Estimating an addition from those central banks which declare they hold Aussie but do not declare how much (including Malaysia and Hong Kong) leads us to the US$60bn approximation above.
Clearly we can determine from all of the above that if a central bank wants to hold a currency in its reserves then it does not need to stick to those currencies endowed with reserve status by the IMF. However, reserve status surely provides a sort of “tick of approval” from the IMF, allowing central banks to feel safe in diversifying their holdings into certain currencies.
And diversification has been the name of the game ever since the GFC threw the spotlight on the levels of debt behind the major reserve currency – the US dollar. The US dollar is no longer even afforded a AAA credit rating. Reallocation of central bank portfolios to provide greater risk diversification cannot, nevertheless, happen too swiftly. If we're talking big money, one whiff of a significant central bank move in forex markets would shift exchange rates substantially and kill off the benefit of diversification in the first place. On the other hand, we know that while China would love to reduce its substantial US dollar bond holdings, for example, to do so openly would trash US bond prices and represent a substantial loss of value for China.
It is now well understood that the Aussie dollar cannot simply be considered a “commodity currency” and thus a global “risk proxy” anymore, otherwise it would have fallen below parity with the US dollar long before now. Presently the Aussie is being underpinned by (a) massive foreign investment in Australian-based resource projects, which still have years or decades of construction and running costs ahead of them, and (b) the interest rate differential between Australian bonds and the bonds of the major developed economies, which is unlikely to close anytime soon given global QE ramp-ups and RBA sensitivity to sudden inflation.
In short, the IMF has not done anything to ease the upward pressure on the Aussie.
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