Every three months, global finance analysts scrutinize the International Monetary Fund data on central banks’ foreign-exchange holdings to see if the US dollar is losing its status as the world’s reserve currency.
It is a waste of time because the fund figures are incomplete. More than 40% of the money that could be labelled reserves was not in the fund’s total of $5.03 trillion at the end of 2006.
The issue is not whether the dollar remains the most popular denomination for trade, investments and deposits and the preferred asset for a rainy day. It is, by a long shot.
What people ought to consider, instead, are the huge amounts of cash that countries, in particular Asian nations, such as China, and oil producers, are diverting from their central banks to so-called stabilization funds and other nonreserve official entities.
Morgan Stanley estimates that 24 of these funds hold assets totalling $2.3 trillion. About 90% of those resources are not captured in the official-reserves tally, says Stephen Jen, the firm’s London-based global head of currency research. He predicts these “sovereign wealth funds” will grow by about $500 billion annually, and that in five to six years they may equal the world’s official reserves in size.
There are many countries with such funds, including Uganda, Brunei, Malaysia, Kuwait and Kiribati, the Pacific island nation with a population of about 105,000.
The biggest of the funds are the Abu Dhabi Investment Authority, with an estimated $875 billion in assets; the government of Singapore Investment Corp., with $330 billion—Singapore’s Temasek Holdings with $100 billion; and Norway’s global pension fund, with $300 billion, according to Morgan Stanley.
Most of these funds are highly secretive about where and how they invest. Two major exceptions are Norway and Australia.
Last month, China said it would create an investment agency that analysts project will begin with $250 billion to $300 billion in seed money and quickly grow to become the world’s second biggest fund.
At $1.07 trillion, China holds the world’s largest pool of official reserves, followed by Japan with $884 billion and Russia with $333 billion. Excluding Iran and Iraq, the members of the Organization of Petroleum Exporting Countries have an aggregate $331 billion. Others with large holdings include Taiwan, South Korea, India, Singapore and Hong Kong, which have a combined $975 billion of official reserves.
Foreign-currency reserves are to central banks what spare generators are to hospitals: Backups to keep things running if the power fails. They ensure companies have access to hard currency to pay for imports, that local banks have enough funds to meet demands, and can be used to defend against capital flight. They also bolster a country’s creditworthiness and can help calm financial markets.
There is no set formula for what constitutes sufficient reserve levels. In late March, a US Treasury study asserted that Asian countries were amassing bigger war chests than warranted. No kidding. Asian central bankers—or oil exporters, for that matter—do not need lectures on the obvious.
Most central banks park their reserves in relatively low-yielding, highly liquid government securities, agency debt, money-market instruments and bank deposits. Therein lies the rub.
Increasingly, big reserve holders want a better return on their money. To get it, they are willing to take on more risk.
“Oil stabilization funds have been big investors in Asian equities—particularly in Indonesia, Malaysia and China—in real estate in such countries as Pakistan and locally, and in infrastructure, especially oil and gas,” says George Magnus, a London-based senior economic adviser at UBS. They also allocate money to hedge funds and private equity.
“These are investors who don’t invest according to liquidity criteria, which is what central banks have to do. And they tend to be more total-return-oriented in their asset allocation,” he says.
Why care? The sums are huge, the long-term impact on markets enormous, the lack of transparency disturbing.
The shift to more aggressively managed funds will be positive for risky assets, especially stocks and emerging-market securities. Last November, Knut Kjaer, head of Norway’s fund, said a 40% allocation to stocks may be too low.