The facts contradict the story

The most authoritative sources of reserve currency allocation are the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). Their most recent data covers the second quarter of 2006.

This data indicates at the end of 2006’s second quarter the dollar’s share of reserves slipped from 66.1 percent to 64.8 percent while the euro’s share rose from 24.8 percent to 25.6 percent. Together, the sterling and the yen made up only 7.5 percent. (Note: Not all countries report the allocation of their reserves.) These modest figures seem to show only the slightest shift in reserve diversification. Why?

Valuation. For example, suppose you are a central bank with reserves evenly divided between dollars and euros. Over the past year the euro has risen almost 15 percent vs. the dollar. You are a patient central bank and have done nothing, but because of this valuation shift, the proportion (i.e., the net value) of your euro reserves has increased while the proportion of dollars has declined. This change in currency values gives the appearance of a greater shift away from dollars than is actually the case.

The data shows central banks that report their currency reserve compositions hold more dollars than ever before, but they also hold more euros than ever before — it’s not a zero-sum game. In fact, if there has been any trend in reserve diversification, it seems to be out of yen and into the British pound.

In the past many economists have argued that central banks could be thought of as long-term countertrend speculators — that is, when the U.S. dollar is weak, central banks intervene and buy it. Siwei’s comment implies just the opposite — that the People’s Bank of China would be a long-term trend speculator. The last central bank to reportedly engage in such practices was Bank Negara (Malaysia’s central bank) in the 1990s, which abandoned the strategy after suffering sufficient losses.

Also, the “dollar overhang,” or world’s dollar surplus, is not as large as often portrayed. True, although the U.S. economy comprises about one third of the world’s economy, the dollar makes up almost 65 percent of the currency reserves. This discrepancy, however, is not a fair measure of the dollar overhang because the countries formally or informally tied to the U.S. economy — the “dollar-bloc,” if you will — comprise approximately two-thirds of the world economy. This figure is more in keeping with the dollar’s reserve percentage.