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Developed Market Sovereign Bonds: Dollar doldrums

But that means the US faces the dilemma that economist Robert Triffin raised in the 1960s: acting as the sole reserve currency means having to run a permanent current account deficit, importing goods to maintain the rest of the world’s supply of dollar liquidity; but thereby risking loss of confidence in those dollars. 

This is why the current dollar-dominated monetary system remains unstable and arguably a major contributing factor to the global financial crisis. Jerome Booth, former head of research at Ashmore and author of the book, ‘Emerging Markets in an Upside Down World’ (Wiley 2014), argues that continued maintenance of the dollar as the central feature of the international monetary system would require not only a reduction of current global imbalances, but measures to avoid a repeat – a credible commitment by the US Federal Reserve to subjugate domestic interests to global interests in determining monetary policy. “This seems politically inconceivable,” he concludes. 

Is the dominance of US dollar Treasuries in the reserves of central banks therefore likely to change – and if so, what are the repercussions?

Despite the long-term prognosis, moves away from US dollar holdings have been very slow so far, says Laurent Crosnier, CIO of Amundi, London. As he points out, IMF data indicates that 61% of foreign reserves in Q4 2013 were in US dollars. Moreover, Booth says the IMF figures exclude both China and Saudi Arabia, which are thought to have even higher-percentage holdings. 

The euro has been the next largest reserve currency, reaching a peak of 28% in Q3 2009 in IMF statistics. However, unsurprisingly it declined during the euro-zone crisis. In recent years, the most remarkable change has been the rise of the share of reserves held in Australian and Canadian dollars, says Crosnier. 

“There is a move towards a multi-polar world,” says David Smart, managing director of strategic advisory for Franklin Templeton Solutions. “Assuming it remains intact, the euro will become a more significant portion of FX reserves as Europe is such a large exporter. But it probably requires a federal bond market replacing individual countries, since while the German Bund market may be liquid, other European sovereign bonds are not.”  

Over 80% of global reserves are held by emerging market central banks according to Booth, and their collective investments have led to a lowering of bond yields in the US and other developed countries, which arguably contributed to the debt-fuelled boom and bust in the US. Yet there is no real consensus on what the objectives of individual central banks should be. This is reflected in the widely varying and competing behaviour among them. 

Asian central banks built up their reserves following the crisis of 1997 when it became clear that, without adequate reserves, their currencies were vulnerable to speculative flows at a time when their sovereign debt was predominantly issued in dollars. Yet having built up huge reserves, there has been little debate on what should be the appropriate amount – recent experience suggests that countries with larger current account deficits require more than they originally thought – and in which currencies and assets should they be stored. 

Alternatives to the US dollar is the key issue as countries grapple with a competitive trade environment. Few would advocate a return to gold. One alternative would be to use a synthetic basket of currencies such as the IMF’s Special Drawing Rights (SDRs). The SDR itself is unsuitable in today’s world as it is a basket of only developed world currencies – but moves towards a broader basket are already occurring and this has both theoretical and practical advantages. 

Booth argues that there are a number of reasons why emerging market central banks will have to cease buying US Treasuries. Higher local exchange rates will be an incentive for local firms to reduce exports in favour of domestic consumption as well as fighting inflation by reducing the costs of essential imports such as oil. Liquidity management becomes more important as the risk of many central banks selling dollars simultaneously increases. And reserves are becoming so large that they are increasingly seen as a store of wealth – which is not compatible with the low returns associated with US Treasuries.

As Booth points out, Brazil, which is competing with Korea in many exports, would find it beneficial to sell US dollar reserves and buy Korean won, thereby raising the exchange rates of a major competitor. Perhaps the most conceptually attractive for a central bank would be having a trade-weighted portfolio of sovereign debt based on country-of-trade rather than the currency-of-invoicing. But Crosnier argues that a trade-weighted portfolio of sovereign debt would make sense only if the relevant sovereign bonds were sufficiently liquid. “The larger the foreign reserves, the easier it is for a central bank to converge towards a trade-weighted portfolio of sovereign debt,” he says. 

In practice, the most appropriate trade weightings can be both difficult to measure and can change rapidly. In a world with no constraints, the eventual target may be GDP weights.

The most rapid change in the current framework has been the rise of the Chinese renmimbi (RMB). Chi Lo, the senior China economist at BNP Paribas Investment Partners, points out that the RMB is now used to settle 18% of China’s total trade, up from 3% in 2010. Central Banks have been important in the push to internationalise the RMB and People Bank of China’s (PBoC) swap arrangements with other central banks have become commonplace. “Between 5% and 10% of total central bank reserves in Asia are currently in RMB and Nigeria recently announced that 10% of their reserves will be in RMB,” he says. 

Adeline Ng, head of Asian fixed income at BNP Paribas Investment Partners, points out that one obstacle has been the lack of a suitable international benchmark for RMB bonds – now remedied with the launch of the FTSE-BOCHK Offshore RMB Bond Index Series in October 2013. The timescale for the rise of the RMB is still uncertain though. As Smart points out, it will take a long time for China’s capital markets to develop depth, liquidity and settlement procedures comparable to those of the US.   

Change is coming in central bank portfolios around the world. It will be slow going, perhaps punctuated by liquidity crunches – and the end result may be much greater diversity that reflects individual trade relationships. But however long it takes to get there, it seem inevitable that the role of the US dollar, and US Treasuries, will diminish. The consequences of that should exercise anyone working in global sovereign debt markets today.

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