Global FX reserves set to drop, halting diversification out of dollar

Central bank foreign exchange reserves may have fallen last quarter for the first time since the global financial crisis, halting a decade-long shift out of dollars and threatening a key support for the euro and Australian and Canadian dollars.

Ever since the dollar’s rise accelerated in July on expectations that the Federal Reserve could start raising interest rates next year, forex reserves held by central banks have started to fall from record highs.

And with Russia in crisis, fears have grown that central banks from South Korea to Turkey and Indonesia would have to draw more from their reserves to stem a flight of capital and prevent sharp local currency losses feeding inflation and hampering foreign-currency debt servicing.

Analysts at RBC Capital Markets estimate global reserves are 2 percent lower in the third quarter compared with the previous three months.

The International Monetary Fund is set to issue reserves data at the end of December.

That would translate into a $240 billion drop in global reserves, estimated at $12 trillion, and the first fall since late 2008/early 2009. Two-thirds of global reserves are held by emerging market economies, with China holding the bulk.

“Central banks typically have fixed ratios that they allocate to dollars, euros and other currencies in their reserves,” said Neil Mellor, strategist at Bank of New York Mellon.

“So if overall reserves are shrinking, you have to sell euros and other currencies so that the ratios are maintained. The decade-long diversification process which has helped the euro will reverse and the euro will be the hardest hit.”

The U.S. dollar’s share of global foreign currency reserves was around 61 percent and the euro’s 24 percent at the end of the second quarter, based on IMF data.

That compared with 61.8 percent and 23.8 percent respectively in the same period of 2013. In 1999, when the euro was introduced, the single currency’s share was 17.8 percent, but that has steadily risen, mostly at the expense of the dollar. During that time, the euro has gained almost 20 percent against the greenback.

“In the past, passive diversification by sovereigns has compressed volatility, boosted the euro and high-yield G10 currencies,” said Geoffrey Yu, currency strategist at UBS.

“With higher U.S. rates, emerging market central banks will probably be busier defending their own currencies and drawing down reserves. As such, outflows from China and general reserve declines across emerging markets will likely become the norm.” (Reuters)