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G20 needs to watch stability of reserves stockpile

Source: Reuters - Mon 24th May 2010

Future stability of the world's biggest bond markets lies largely in the hands of about 14 central banks holding trillions of dollars in currency reserves banked in as much as half the world's tradeable government debt.

Yet, Western governments' biggest creditors - even mindful of average budget deficits next year in the United States, euro zone and Britain in excess of 8 percent of national output - have little choice but stay on autopilot.

The sheer scale of global reserves - some $8 trillion (5.6 trillion pounds) held largely by China, Japan and developing countries across Asia as well as oil exporters like Russia and Saudi Arabia - means any major shift away from existing holdings now would likely sink the very investments central banks are trying to protect.

In a development once likened by White House economic adviser Lawrence Summers to "mutually-assured financial destruction", currency-pegging central banks of the developing world have more than quadupled holdings of dollars, euros, sterling and yen in just 10 years and banked them in corresponding government debt.

This effectively subsidised the borrowing of U.S. and European governments, their firms and households; underwrote consumption of exports from the reserve builders; and facilitated an explosion of Western government borrowing with barely any interest rate penalty.

But as private investors now grow increasingly wary of Western debt mountains, the scale of interdependency between the richest, most indebted section of the Group of 20 economies and developing nations within that group has intensified.

And the test of the G20 as a global economic steering body may now be how it defuses what has become an almost involuntary financial "arms race".


Citigroup currency economist Steven Englander points out global reserves have risen to well over 50 percent of all outstanding government bonds from just over a quarter in 2000.

The big four liquid world currencies dominate. About two thirds of reserves are held in dollars, about a quarter in euros and about 3 percent each in sterling and yen.

But even a 5 percent change in reserve allocations now would require a seismic shift of $400 billion across currencies - something that would see all financial prices cascade in its slipstream.

The giant and liquid U.S. Treasury market frequently shivers on speculation about the behaviour of the big reserve holders but the impact of any shift in direction on smaller markets such as British gilts could be chilling.

Raphael Gallardo, head of macro economic research at Axa Investment Managers in Paris, says sterling reserves imply central bank managers hold almost a quarter of the entire 800 billion pound gilt market. Just a one percentage point reduction in the sterling share of their reserves would hit the market by up to 50 billion pounds.

More immediately, the euro zone's existential crisis over Greece's risk of default and the danger of contagion across the zone has raised concerns about reserve managers rethinking their gradual, decade-long diversification from dollars to euros.

With euros now accounting for about 25-30 percent of world reserves, or about two trillion euros, the risk of the slightest shift in percentages is treated with great caution.

Stephen Jen at BlueGold Capital Management estimates that the 10 percent drop in the euro/dollar exchange rate this year would have seen the top eight reserve holders taking a valuation hit of as much as $200 billion - China taking an $80 billion hit, Russia $14 billion and $7 billion for South Korea.

Although valuations ebb and flow with the vagaries of currency markets, they do illustrate the scale of the reserves game in 2010 and Jen said this could prompt a destabilising rethink on global holdings at large.

"Central banks' reserve managers are presumably reconsidering their dollar diversification strategy, now that the euro is also found to be less than a perfect 'anti-dollar'" said Jen, referring to the rise in the euro's share of world reserves from 18 percent at its launch in 1999.

Axa's Gallardo also thinks the long-standing policy of seeking diversification from dollars could be reconsidered.

"We may see gradual reverse diversification from the euros and sterling back to dollars," he said.

But here's the bind. Such a shift could be so devastating to the markets in question that central banks would end up taking even bigger losses on their portfolios than already experienced, and ensuing global financial turmoil - as seen recently with Greece - would require action at G20 level anyway.

As a result, Englander at Citi doubts reserve managers will upset the apple cart and he showed that, adjusting for valuation effects, relative allocations between currencies has actually changed little since 2002.

He said that at the margins they might instead consider adding more relatively liquid currencies from other more fiscally sound countries such as Canada or Australia.

"The likely outcome on the margin is that reserve managers in the short term will diversify out of G3 when possible and in the long term consider policies to significantly reduce the pace of reserve accumulation."

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