Sovereign credit concerns, low interest rates reshaping world reserves

After years of being also-rans, currencies from countries such as Canada, Australia, China, Brazil, Russia and Norway now have a realistic chance of breaking deeper into the $11 trillion global reserve mix.

Such a move, if it came, could encourage billions of dollars in private investment to ride along in the slipstream.

Deteriorating sovereign credit quality across industrial economies has already begun to push central bank asset managers to diversify away from the traditionally dominant U.S. dollar, euro, Japanese yen, British pound and Swiss franc.

The latest IMF report - the only official data on how reserves are managed - showed central bank holdings of currencies such as Australian and Canadian dollars jumped 25 percent to 6.1 percent at end-2012.

That's small compared with the 85 percent still held in U.S. dollars and euros. But it points to the future.

Central bank reserve diversification is being driven by two things - the near zero official interest rates in the advanced world and the series of sovereign credit rating downgrades in major economies over the past year or so.

The low interest rates drive up the cost in domestic currency terms of building a huge overseas cash piles. The downgrades simply mean traditional safe havens do not seem as safe as they were.

The United States, France and Britain have lost triple-A endorsement from at least one credit agency. The latest hit to reserve credit quality came last Friday when ratings firm Fitch became the second agency to strip Britain of its top AAA rating.

"Central bank and official holders of reserves, like everyone else, are worried about incipient inflation, (but) they are also worried about declining credit quality among sovereigns," said George Hoguet, global investment strategist at State Street Global Advisors.

"The commodity currencies in general have significantly better balance sheets, certainly than the euro zone. It's understandable that they would move to diversification."

The annual survey of 60 central banks released this month, compiled by Royal Bank of Scotland for Central Banking Publications, showed two thirds of them are considering or would consider investing in China's yuan, while 40 percent of them said the same about investing in the Brazilian real, Danish crown and Indian rupee.

Around one in three is considering or would consider Norwegian, Swedish and Danish crowns, Russian rouble and New Zealand dollar.

"This (diversification) should stabilize the international monetary system by helping balance the investment flows and encourage (a) more long-term investment horizon into the new reserve currencies," one reserve manager at an Asian central bank told the survey.


The desire for other currencies is driven by the imbalance in the demand and supply of safe-haven assets as well as the rising cost of holding a huge cash pile.

Backed by strong export growth, emerging economies have built up shock-absorbing precautionary reserves via central bank intervention to cap local currencies. But that very financial operation generates a large "cost of carry" in the process.

For example, China's central bank buys U.S. dollars to keep a lid on the yuan exchange rate in order to keep its exports competitive. In doing so, the bank sells yuan to its local banking system and then needs to sell yuan bonds to prevent the excess yuan seeping into the economy and stoking inflation.

It is then losing the difference between what it earns on its accumulated U.S. dollars - typically held in Treasury debt - and what it pays to its banks via the yuan-denominated bonds.

Tufts University researchers estimate this cost has grown to 3 percent of gross domestic product. For all emerging economies, it has grown to 1.8 percent of GDP from 1 percent in 2004.

Another study by Gioia Cellai and Francesco Potente at the Bank of Italy for Central Baking Publications showed the scale of a shrinking supply of top-rated debt.

In Europe, the size of outstanding debt with credit default swap rates below 100 basis points - one of the "safety" thresholds used - fell by a third to 4.7 trillion in the three years to 2011. That represents less than 50 percent of total outstanding debt, compared with more than 90 percent in 2008.

At a global level, the weight of debt deemed as a safe haven against the total debt fell by more than 15 percent in the same period.

"One desirable scenario for the coming years could be a gradual reduction in the concentration and polarization of the safe asset universe...(That) would require prudent fiscal policies, major regulatory changes and a deepening in the local sovereign bond markets," Cellai and Potente wrote.

"The increased creditworthiness and liquidity may lead investors to gradually recognize the suitability of such bonds for meeting their safety needs, thus contributing to an increase in supply."

(Additional reporting by Carolyn Cohn, editing by Jeremy Gaunt)