Reserve diversification, Part II

The biggest threat to the dollar — and to U.S. prosperity — is the chance the Chinese government will dump its roughly $700 billion in dollar- denominated reserves, as it has hinted it will. The sum of $700 billion is only fairly large in the forex universe, but the psychological effect of such action would be huge. It would reverberate throughout the financial world, inducing others to diversify reserves into euros, the British pound, the low-yielding Japanese yen, and even zero-yielding gold.

Reserve diversification has already become a big deal. The Bank for International Settlements recently reported the dollar has slipped from 67 percent of the world’s reserves to 65 percent. On Dec. 18, the Iranian government directed its central bank to switch all its external accounts to the euro. Over the past year, Banco Central de Venezuela raised the percentage held in euros from 5 percent to 15 percent (its total reserves are $35.9 billion), with the United Arab Emirates choosing to move as much as 8 percent of its $24.9 billion reserves into euros. The central bank of Indonesia is also seeking a higher proportion of euros in its total reserves of $39.9 billion.

In its year-end review, the Swiss National Bank said its reduction of dollar assets has improved its risk-return profile.

“One example of a poorly compensated risk, from the point of view of a Swiss franc investor, is the U.S. dollar currency risk on bonds,” the bank wrote. “Our experience has been that expected earnings on bonds in other currencies, such as euros or sterling, are comparable, while currency risks are significantly lower. Consequently, and also because another important reserve currency was available in the form of the euro, we have substantially reduced our share of U.S.-dollar investments over the past few years.”

As central banks go, the Swiss National Bank is probably highest on the list for the reserve-management function, and its reduction of dollars, embrace of gold, and diversification to equities is not going unnoticed in the petrodollar countries and Far East. Like the Swiss, the Chinese are already contemplating a “special purpose agency” to divert some of its massive reserves into an actively managed fund that would seek higher returns.

Such a fund could contain equities, real estate, stockpiles of oil and other commodities — anything. If the special purpose agency invested in non-liquid assets, they probably wouldn’t qualify as “reserves” anymore. The purpose of foreign exchange reserves is to have enough money to buy food and energy for several months in the event of a catastrophe. If you have already stockpiled food and energy sources, aren’t you achieving the same purpose without the currency risk?