By: John Mackenzie | Wed, Jan 26, 2005
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Central Banks Reduce Dollar Holdings, Survey Shows (Update5)

Jan. 24 (Bloomberg) -- Central banks are reducing their holdings of dollars in favor of the euro, according to a survey of 65 central banks, extending a three-year trend identified by the International Monetary Fund.

Almost 70 percent of the 56 central banks that provided details of changes in their reserves said they boosted holdings of the 12-nation currency, according to the survey sponsored by Royal Bank of Scotland Group Plc. Fifty-two percent said they reduced the share of dollar holdings. Nine central banks either reported no change or didn't answer the question.

The dollar lost 7 percent against the euro in the fourth quarter, falling to a record $1.3666 on Dec. 30. The currency's three-year decline may spur central banks to pare the proportion of their reserves held in dollars and make it harder to finance the U.S. current-account deficit, said Robert Pringle and Nick Carver, authors of a report on the survey's conclusions.

"The overwhelming trend we've seen is increasing exposure to the euro," said Carver, an assistant editor at Central Banking Publications Ltd., the London-based publisher which conducted the survey. "Central banks have started to take the euro more seriously."

Royal Bank of Scotland is the ninth-largest foreign-exchange trader, according to a 2004 Euromoney survey, accounting for 3.5 percent of the $1.9 trillion-a-day currency market.

'Dollar Bears'

The dollar fell to $1.3089 per euro as of 11:15 a.m. in London, after gaining 0.6 percent last week, according to EBS, an electronic trading system. The U.S. currency was at 102.87 yen, after advancing 0.7 percent last week to 102.70.

The survey "is reminding people that the U.S. does have a funding problem in its current account and reinforces the views of dollar bears," said Marvin Barth, a currency strategist at Citigroup Inc. in London and a former Federal Reserve employee. "This is very much a longer-term issue."

The share of dollars in total reserve holdings was 63.8 percent at the end of 2003 from 63.5 percent in 2002 and down from 66.9 percent in 2001, the IMF said in its annual report in April 2004. The euro proportion rose to 19.7 percent from 19.3 percent in 2002 and 16.7 percent in 2001.

Central banks may trim the proportion of reserves held in dollars to about 60 percent in coming years, said Barth.

The dollar, up about 3.5 percent this month, may in 2005 end a three-year decline against the euro, according to a Bloomberg survey of 53 traders, strategists and investors published on Jan. 7. Forty-eight percent of people questioned separately on Jan. 21 advised buying the dollar against the euro this week, up from 40 percent a week earlier.

Current Account

The dollar lost more than six cents against the euro between Nov. 19 and the end of 2004 after Fed Chairman Alan Greenspan told the European Banking Congress in Frankfurt that foreign investors will tire of financing the current account deficit and channel their money into other currencies.

"While central banks will continue to some extent to finance the American current-account deficit, the United States cannot rely on this source of finance to the same extent as in the past," Pringle and Carver wrote.

The deficit in the current account, the broadest measure of international trade, rose to a record $164.7 billion in the third quarter. To compensate for the gap and maintain the value of the dollar, the U.S. needs to attract about $1.8 billion a day, or about $55 billion a month, based on Bloomberg calculations.

Shift in Reserves

The dollar fell against the euro on Nov. 23 after Russian Central Bank First Deputy Chairman Alexei Ulyukayev said the country may lift the amount of euros in its reserves.

"Most of our reserves are in dollars and that's a cause for concern," Ulyukayev told reporters in Moscow the same day. "It's a real problem. Looking at the dynamics of the euro-dollar rate, we are discussing the possibility to change the reserve structure."

More than half of those polled said they've decreased the portion of dollar holdings in about the past two years. Twenty- seven percent said they've done the opposite. Twenty-nine percent said they cut the share of reserves held in yen and 11 percent said they increased it. Forty percent stepped up accumulation of British pounds.

The survey doesn't provide an estimate of the total proportion of reserves held in any currency. Carver declined to identify any of the central banks questioned.

Cheese Platters

In the Financial Economy the most important economic indicator is the Money Supply.

Historically is has had a direct relationship to the level of Interest Rates, Rate of Inflation and Real Economic Activity with the Economy. The Federal Reserve regulates aggregate Money Supply through several policy measures designed to act as Levers.

- The Federal Reserve can require Member Banks to have higher or lower percentages of its deposits on reserve that cannot be borrowed against.

Reserves are composed of funds on deposit at the Fed and cash on hand. A member bank may have met the Reserve Requirement and still be insolvent.


If the Member Banks total Asset Base, does not cover or exceed its liabilities. A Member Bank can borrow within the market for money or simply ask the Federal Reserve for additional funds in order to meet its reserve requirements.

Borrow to meet the requirements?

Yes, it is as it appears, Member Banks can assume additional Debt in order to create more Debt.

A Member Bank's solvency is in question as soon as it begins lending capital that exceeds liabilities. The Reserve requirement imposed by the Fed lowers the limit on the Member Bank's capital available to service its risk; providing a margin of error in order to mitigate insolvency.

The Reserve Requirement is claimed to limit a Member Bank's deposit creation through lending.

This is, of course, impossible in a Financial Age where Interest rates that Member Banks charge reflect a Member Bank's true Operating Costs. The required Reserve Ratio is currently set at 10%. There is no interest paid on Reserve Balances for 14 days, the period for computing reserves. 0% is allowed without penalty during this period; trending towards a zero reserve system.

Open Market Operations appear to be illustrating the stress as they are being used to "compensate" for 0 to 28 day imbalances between inflows and outflows. There are several resources for tracking the aggregate Federal Reserve Desk operations in the form of Temporary, Permanent and Long Term Securities Lending. These should be observed carefully.

- The Federal Reserve can change the Nominal Interest Rate on funds that Member Banks borrow directly from the Federal Reserve.

The "Discount Rate" is the interest rate charged by the Federal Reserve when banks borrow from the Fed on an overnight basis. The Federal Reserve controls this rate directly. This rate is lower than the Federal Funds Rate. The Federal Funds Rate is the interest rate charged by large Member Banks when smaller Member Banks borrow overnight from one another. This rate is based upon the supply and demand for funds and is not under direct control of the Federal Reserve, although they may issue a "target rate."

Confused? Not to worry.

The Federal Reserve manages their "Funds Rate" through its Open Market Operations. The Fed sells US treasury securities to Member banks. The Member Bank Reserves at the Fed decrease. Member Banks, I suspect, no longer have to maintain the Reserve Requirements at the Federal Reserve.

Figure 1: Why? The London Inter-Bank Rate Chart illustrates it clearly.

The Discount Rate lags changes in the Federal Funds Rate.

When the spread between the Fed Funds rate and Discount Rate widens, large Member Banks capture this spread by borrowing from the Federal Reserve at the Discount rate by lending to smaller Member Banks at the Federal Funds Rate.

The Federal Reserve independently moves the discount rate in order to increase or decrease activity.

- The Federal Reserve can actively purchase U.S. Treasury Bills, Notes and Bonds on the open market. They, of course, pay for them by creating money from their position of privilege.

Of course, this was done in large part by proxy; through large inflows from Foreign Central banks.

Demand for Treasury Paper has historically had and inverse relationship upon these instruments Yield.

The intent is ongoing "Bubble Maintenance" across a large spectrum of Asset Classes, but primarily, Real Estate.

Foreign holdings of U.S. Dollar based Assets have grown significant. This phenomena has significant implications affecting the relationship between the money supply, inflation and interest rates and well may be causing some sleepless nights at the Federal Reserve.

The Federal Reserves tightening monetary policy puts these delicate relationships balance in question.

Contrary to popular opinion at the Federal Reserve... or perhaps not, given they contrarian propensity applied to the Fed’s endless stream of public pronouncements; I suspect the Fed is "panic mode" with respect to the velocity of money in circulation, which appears to be diminished along with the fall in LIBOR rates in Figure 1.

How they react will be very telling in the weeks to come.

If history is any guide, I do believe we are quickly entering the point in time where the Federal Reserve will be forced to take "extraordinary measures." We will need to carefully observe the upcoming G7 meeting, as it will have broad ranging effects upon all Asset Classes.

Kind Regards,


Author: John Mackenzie

John Mackenzie

John Mackenzie manages private capital.

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