What Will the Impact of Continued Central Bank Reserve Diversification Be?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

The U.S. dollar's importance as a reserve currency has been declining for more than a decade. The highest percentage, 70.9 percent, was reached in 1999 as compared to the 2010 level of 61.4 percent. The value of the dollar, as measured by the Dollar Index (DXY), has declined over the same period. The DXY peaked at 121.02 in 2001 when the dollar still made up 70.7 percent of global reserves. The following year the reserve percentage dropped to 66.5 percent and the DXY dropped to 101.80. The decline in the dollar's reserve percentage over the last 11 years from 70.9 percent to 61.4 percent, was mirrored by a decline in the dollar's value as measured by the DXY from 121.02 to 75.63. The moves in the DXY are a multiple of the corresponding moves in the reserve percentage for several reasons; one is that while the reserve number is an absolute percentage, the index reflects the compounding effect of selling the dollar and also buying another currency. Other factors which may distort the relationship between the two measures are the inclusion of gold, SDR's and IMF reserve positions in the reserve totals.

There is a good chance that this trend will continue according to a recent survey of central bank reserve managers, sovereign wealth funds and multilateral institutions. The survey, which was carried out by UBS (Union Bank of Switzerland), the largest Swiss bank, predicts that a portfolio of currencies, rather than the dollar, will be the main currency reserve component within the next 25 years. This marks a departure from previous years, when the central bank reserve managers have said the dollar would retain its defacto status as the world's sole reserve currency.

The results showed that 52 percent of those surveyed expected that the SDR*, or a portfolio of currencies, would be the global reserve currency in 25 years. The dollar came in a distant second at 27 percent; Asian currencies were third with 11 percent; gold was next at 6 percent; and in last place was the euro with 4 percent.

The survey participants were more than 80 central bank reserve managers, sovereign wealth funds and multilateral institutions with more than $8,000 billion in assets.

The results are partially a sign of dissatisfaction with the dollar as a reserve currency, amid concerns over the U.S. government's inability to rein in spending and the Federal Reserve's huge expansion of its balance sheet.

But if these were the determining criteria, the participants would not be buying euros either. Nevertheless, the U.S. currency has slid 5 percent so far this year, and is trading close to its lowest ever level against a basket of the world's major currencies.

Holders of large reserves, most notably China, have been diversifying away from the dollar. In the first four months of this year, three quarters of the $200 billion expansion in China's foreign exchange reserves to a record $3.045 trillion was invested in non-U.S. dollar assets, Standard Chartered estimates. Additionally, Russia, Taiwan, Brazil, India, South Korea, Singapore (which have a total of $ 2.1 trillion in reserves) and a score of smaller nations have been following a similar course.

The prediction of a multipolar currency world replacing the current dollar dominance aligns with the thinking of some leading policymakers. Robert Zoellick, president of the World Bank, has proposed a new monetary system involving a number of major global currencies, including the dollar, euro, yen, pound and renminbi. This system should also make use of gold, Mr. Zoellick added. The results of the poll also point to a growing role for bullion, with 6 percent of reserve managers surveyed saying the biggest change in their reserves over the next decade would be the addition of more gold. In contrast to previous years, none of the managers surveyed was intending to make significant sales of gold in the next decade.

Central banks have bought about 151 tons of gold so far this year, led by Russia and Mexico, according to the World Gold Council, and are on track to make their largest annual purchases of bullion since the collapse in 1971 of the Bretton Woods system, which pegged the value of the dollar to gold. The reserve managers predicted that gold would be the best performing asset class over the next year, citing sovereign defaults as the chief risk to the global economy.

Since gold is priced in dollars, increasing gold reserves also increases dollar reserves, which, for the central banks wishing to reduce the percentage of their reserves held in dollars, will need to be offset by selling dollars for another currency. Gold has risen 19.5 percent in the past year to trade over $1,500 a troy ounce, which also means more dollar reserves which potentially need to be hedged.

The reserve flows are certainly not the sole determinant of the value of the dollar, but their influence, over time, should not be underestimated. As both the U.S. and Europe are currently facing uncertain financial and economic futures and are now operating from position of relative weakness, it is difficult to assess which currency will be stronger in the future. What does seem certain is the ongoing decline in the percentage of reserves held in dollars and the negative impact this will have on the value of the dollar. This policy shift coincided with a decline in the value of the dollar of 35-40 percent over the last decade and its continuation may well lead to a similar move over the next five to ten years. A EUR/USD rate approaching 2.00, USD/CHF at 0.60, USD/CNY at 4.20 and GBP/USD at 2.15, are all potential levels for the dollar looking forward using the past impact of the shift in reserve policies.

*The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries' official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies.