Boom2Bust.com

Weekend Edition: July 28-July 29, 2007

Last week, I published “The Dollar Crisis Examined” where I discussed the huge concentration of U.S. dollars overseas. If foreigners stop accumulating dollars, U.S. stock and bond prices, as well as the dollar, will plummet in value. Here in the United States, we will see higher import prices, inflation, and the erosion of consumer purchasing power. On July 20, I told readers that I’d look overseas for any sign that foreigners are growing weary of the U.S. dollar. My research shows that central bank dollar holdings continue to climb, despite all the diversification talk. On June 30, Reuters reported that the global central banks had hit a record in reserves held in U.S. dollars at $2.24 trillion in the first quarter. Dollar holdings in the International Monetary Fund data, which covers about two-thirds of the world’s currency reserves, remained around the 65% level, roughly the same as in the previous 3 years. In the days prior to the Reuters article, the European Central Bank said the euro’s share in global reserves had also remained stable since 2005, which suggests that the U.S. dollar is still preferred by the central banks. Brad Setser, an economist at NYC-based Roubini Global Economics, told Reuters that as long as these two trends continue, “The overall story is one of more central bank demand for dollars, not less.”

However, some analysts are starting to question the sustainability of the rise in dollar reserves. “We don’t see any significant sell-off in the positions foreigners currently have in Treasury and agency debt, we do see the pace of investment beginning to decline, which will prompt a further decline in the US dollar,” said Bank of New York strategist Michael Woolfolk to Reuters on June 30. Emma Lawson, currency strategist at Merrill Lynch, added she expects emerging markets, like China with its $1.2 trillion in reserves, to let their currencies appreciate further on in 2007 in order to stem capital inflows and cool inflation. To achieve this requires the Chinese central bank to buy fewer dollars, adding downward pressure to the currency, and force other central banks to actively increase holdings in other currencies over the coming years. Furthremore, state-run investment funds, using a portion of reserves that usually go to U.S. securities, may also work against the dollar.

It’s interesting to note that China reduced its holdings of U.S. Treasuries to $407.4 billion from $414.0 billion in May, the second month in a row China cut such holdings. Chris Turner, currency strategist at London-based ING Groep NV, told the Wall Street Journal on July 18 that the drop may reflect “custodial practices.” Still, Mr. Turner said further changes in Chinese holdings need to be watched, as another decline “may add to fears that China is quietly finding more-valuable investment products than U.S. Treasuries — an activity that potentially accounts for some of the heavy [U.S. dollar] losses seen over recent weeks.”