Can Asia afford to dump the $?

ANALYST'S VIEW/ HDFC BANK'S ECO TALK

Over the last decade, Asian reserve holdings have played a critical role in supporting the dollar and helping finance the current account deficit.

In the wake of the macroeconomic instability in the US and the perceived vulnerability of the dollar, the Asian central bankers are being bombarded with advice to dump their dollar holdings and shift to other currencies. We would argue that this might be an irrational strategy to follow for the Asian banks. While mild diversification purely based on profit consideration is perhaps warranted, any major diversification is likely to go against their interest.

The key to the argument lies in the role of the US in absorbing goods and services. At first glance, the US' share of roughly 18 per cent in all Asian exports might not appear very large.

However, one must recognize that the 34 per cent share of intra-regional trade in the Asian export basket is misleading and consists of a large proportion of intermediate products. (The Monetary Authority of Singapore estimates that only 22 per cent of intra-regional exports in Asia are destined for consumption within the region). Adjusted for this, the US would actually have a much larger share.

Can Euro zone be a substitute for the US? It is true that Asia's exports to the Euro zone are fairly significant at a little less than 15 per cent.

However, Europe is a relatively difficult market to penetrate for a number of reasons, including the need to absorb the tradeable output of Eastern Europe. This is reflected in the correlation between exports growth and that of non-oil imports. Asian exports have a stronger correlation with US non-oil import growth than with growth in G-3 non-oil imports.

In short, Asia still depends upon the US for its export engines. A large shift away from reserves would potentially have two effects:

It would break the implicit dollar pegs in their currencies and drive erosion in their competitiveness vis-a vis the US. A pull-out from US bonds would send US long -term interest rates soaring and exacerbate a US slowdown. This, in turn, could dampen demand for the Asian economies.

The bottom-line
It is unlikely, in our view, that the Euro will in the foreseeable future replace the dollar as the principal reserve currency. We envisage a situation where there are two key reserve currencies with the dollar continuing to dominate. We see a slow upward drift in the proportion of Euro holdings in global reserves with roughly about a 5 per cent increase in its share over the next 4-5 years. Given the upward pressure on the Euro and the possibility of correction in the next year, the process could decelerate in 2008.

Risks for the dollar increased emphasis on returns.

While the possibility of large scale diversification seems to go against the strategic economic interests of Asian economies, it is also true that there has been increased emphasis in the recent past on generating higher returns on reserves.

Most reserve-rich economies have chosen to do this by transferring part of their reserves to special vehicle (the China Investment Corporation, for example) than invest in an array of investments, including private equity and commodities.

Greater emphasis on returns does not necessarily entail a switch away from dollar assets to Euro assets. In fact given the fact that over the last few months both the dollar and US assets have been beaten down quite significantly, there could actually be increased reserve flows into dollar assets (There is some evidence that sovereign funds are buying into US financial sector assets).

However this kind of reserve management strategy breaks the relationship between reserve accumulation and investment in treasuries. However if the dollar continues to depreciate and the US lapses into a deep recession that affects asset earnings, the return seeking on reserves might entail depreciation for the dollar.