Not everyone sees it this way — yet. The conventional thinking — that the U.S. is in trouble, rather than in the catbird seat, because of the deficit — is still embraced by many. A London outfit named Central Banking Publications has just published its first annual review of central bank management practices, named Reserve Management Trends 2005 (http://www.centralbanking.co.uk/). The report surveys over 60 managers who control $1.7 trillion in reserves. It found that “Central banks are stockpiling reserves at an unprecedented rate. Their war-chest of foreign exchange, now worth almost $4 trillion, has risen by 65 percent in the last four years alone.” The 65 central banks that participated control 45 percent of global reserves, with “up to $250 billion under management,” meaning neither China nor Japan were part of the survey.
Some of the main findings: At the end of 2003, central banks held 70 percent of reserves in dollar denominated assets, financing over 80 percent of the current account deficit that year. However, “The U.S. cannot take support for the dollar for granted…Central banks’ enthusiasm for the dollar seems to be cooling off,” according to the survey.
Nearly half said reserves growth will slow from the recent torrid pace to only about 20 percent over the next four years. Because the income from reserves is important to just about all of them, the dollar’s decline makes it less attractive on a total yield basis, and in some cases, the drop has led to negative real returns. The conclusion is that the central banks will increasingly prefer a stable currency like the euro.
But wait a minute. If the dollar is unstable, why is the euro not equally unstable? After all, unless you are looking at one of the trade-weighted dollar indices, we measure the level and the volatility of the dollar in terms of the euro, which by definition has varied exactly as much as the dollar.
Also, it’s questionable whether the central bank managers really do care about the net income they receive on their dollar investments. Since when is a central bank a “profit center” within a government? In practice, central banks tend to be profitable, but they are also extremely risk-averse.
Reserves are a nation’s net savings, and it’s hard to think of central bank managers leaping from an ultra-conservative management style into hedge fund-type activities.
This is not to say the central banks are not diversifying. But to imagine that central bank diversification is going to have a big effect on the day to day movements of the FX market is to exaggerate for the sake of sensationalism. Meanwhile, something else is going on that constitutes a vote on the sustainability of the U.S. economy and the relative irrelevance of the short-term level of the dollar. Foreign direct investment (FDI), which is almost exclusively from the private sector, is on the rise again. According to a new United Nations report, through the first three quarters of 2004, FDI rose 6 percent from 2003 to $612 billion, the first gain in four years.
As we would expect, developing countries got the biggest chunk, up 48 percent from the year before to $255 billion, of which Asia got $166 billion. Of that, China took in $62 billion (and that’s only what’s reported). Together, China and Hong Kong got 60 percent of overall FDI in Asia.
Foreign direct investment in industrialized countries fell 16 percent to $321 billion, with FDI into Europe down 46 percent to $165 billion. FDI in the U.K. climbed 160 percent to $55 billion, while the U.S. enjoyed a 400-percent gain (to $121 billion dollars) in foreign direct investment, outstripping China to regain the status of the top FDI recipient. Japan, despite efforts to attract investment, saw only a 17 percent rise and only $7 billion.
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