Russia has reignited the hot topic of reserve diversification and this time to the benefit of the Yen.
Alexei Ulyukayev, Bank of Russia's first deputy chairman, announced on Monday that the central bank had started purchasing yen and intends to raise the proportion of the Japanese currency held in their total reserves up to several percent from close to zero at present, Mr. Ulyukayev suggested that the central bank may buy other currencies to add to their coffers as well, but said the majority of the reserve reallocation will be executed in 2007. Nevertheless, the US dollar was immediately impacted as the USDJPY pair fell almost 100 points throughout the trading day, long before the Bank of Russia even started to diversify the bulk of its reserves. Although the FX markets see over $1 trillion worth of volume in daily trading, diversification of Russia's $267.9 billion of international reserves the world's third largest could spell trouble for the greenback in the long run. However Russia is not the only central bank that is diversifying its reserves. Dollar woes may be massively exacerbated, as officials in Beijing have repeatedly hinted that China, whose international reserves are anticipated to reach $1 trillion in the next few days, might gradually reduce its purchases of dollar-denominated bonds and diversify its bank as a hedge against further dollar weakness. Additionally, Sweden's Riksbank, the Central Bank of the United Arab Emirates, Qatar Central Bank and the Central Bank of Syria have all announced intentions this year to diversify their reserves away from the greenback, which has been the key international reserve currency since the end of World War Two. There is already evidence that reserve diversification is well underway: In the month of May, central banks dumped $14.3 billion worth of bonds, the largest amount in over seven years.
Euro The Anti-Dollar Vehicle
In July the UAE Central Bank Governor, Sultan Bin Nasser Al-Suwaidi, confirmed that a strategic decision had been made to shift 10 percent of its $29 billion of foreign exchange reserves into euros. Mr. Al-Suwaidi noted that while the US dollar is still the most important currency for the central bank due to its use in international trade, the euro is gaining strength as an investment vehicle. Apparently, Mr. Al-Suwaidi is not the only official who believes this. Back on April 21, the Swedish Riksbank announced that it has slashed its US dollar reserve holdings to 20 percent from 37 percent, and had boosted its euro assets to 50 percent from 37 percent previously. That day, the EUR/USD surged 94 points. Structural weakness could continue to plague holdings in the US dollar, as countries question the health of an economy with record-setting trade and budget deficits almost every year. Additionally, European expansion has proven to be increasingly competitive against that of the United States. With the US Federal Reserve Bank holding interest rates steady at 5.25 percent and the European Central Bank remaining ever hawkish with plans to raise its benchmark rate from 3.25 percent to at least 3.50 percent, the carry trade differential could eventually turn in the euros direction and make it even more attractive to central banks around the world.
Up and Coming Yen
While the Japanese yen may not stand out as the ideal means of investment for central bank funds due to the Bank of Japans ultra-low interest rates, the currencys popularity may mount with its biggest trading partners, especially at current yen values.. This is likely the case with the Bank of Russia, as Asia buys roughly 10% of Russian exports. With the yen serving as a proxy currency for other Asian countries, namely China, diversifying into yen would be the easiest way to reflect the trade exposure. Furthermore, the yen currently trades at a 10-month low against the US dollar, making the currency relatively cheap and creating an ideal buying opportunity. The Reserve Bank of Australia and the Peoples Bank of China could be up to the plate next, as the commodity-rich Australia exports more than 20 percent of its goods to the land of the rising sun while China sends roughly 11 percent. The outlook for Japan has also become brighter over the past year, as the Bank of Japan rang in the end of decade-long deflation with a 25 basis point rate hike. Growth has been accelerating, and BOJ Governor Toshihiko Fukui has noted that he will normalize rates in line with improving fundamentals. Will the Japanese yen feel the same effects? Many traders, and the Bank of Russia, will be hoping so as they look for gains in currency appreciation as well as yields.
What Will China Choose?
China is the most crucial variable in the discussion of reserve diversification. The Peoples Bank of China said that foreign-exchange reserves totaled $987.9 billion at the end of September, up 28.5 percent from a year earlier. It is literally only a matter of days until rapid inflows cause the total to surge above $1 trillion, by far the largest in the world. While China does not disclose the weightings of their holdings, it is estimated that roughly 70 percent of reserves are held in US dollar denominated debt, such as US Treasuries, 20 percent in euros, and 10 percent in other currencies, including the Japanese yen and Korean won. Any investor would question putting all of their eggs in one basket, so why would China be any different? As the US twin deficits remain a topic of debate, as it has yet to have a visible negative impact on growth, the European Union has been more prudent and has placed restrictions on negative budget balances. Furthermore, although a more risky investment, emerging markets have experienced double digit growth rates. The negatives are beginning to stack up against the US, leaving the greenback in danger as central banks, such as the PBOC, could decide to hedge their bets by the billions and move assets away from the United States into countries like Japan.
