The Monday Edition: Mechanics of US Dollar- Role of Petrodollars & EM Central Banks

By Yaser Anwar, CSC of Equity Investment Ideas

In this week’s Monday Edition I’d like to focus on understanding the mechanics of US$ by analyzing 1) Investor fears and 2) Role of Petrodollars & EM, associated with the US$.

Mechanics of US Dollar

• Investors fret about the huge dollar balances held by oil exporters and emerging Asian central banks. They worry that these holders might opt to diversify their dollar investments into Euros, Pounds, and other currencies (especially high yielding ones). Furthermore, some investors fear that central banks may choose to shift out of dollars when the dollar is weak, thereby exacerbating market volatility.
• In contrast, I believe that both central banks and oil exporters will continue to buy dollars in the coming months, albeit not at the rapid pace of the last few years. Before I tell you why, you need to know a few facts.
• Reserve buildup by emerging market central banks continues to fuel an unprecedented surge in the world’s stock of FX reserves. According to Bank of International Settlements, global FX reserve holdings reached approximately $5 trillion at the end of 06 vs. $4.2 trillion last year.
  

• Emerging markets FX authorities account for nearly 3/4s of the stock of reserves and over 90% of the past year’s increase, with a significant portion of it among oil exporters and emerging Asian surplus countries.
• Given the size and rapid expansion of the reserve stock, FX investors sporadically become vexed that central banks may shift part of their US dollar holdings into the Euro or amass new reserves mostly in Pounds, Euros and Yen, driving the US$ down.
  

• Investors need to understand that periods of dollar weakness are not usually associated with reserve portfolio shifts out of the dollar that would tend to aggravate any downward movement. During my on going FX education, I’ve come to learn that new reserve purchases show that periods of dollar weakness are associated with a rise in the dollar’s share of new reserve purchases. The image below depicts that, the

  US

  $’s position in the allocation of FX reserves has held nearly steady.
• Oil exporting countries have built up a huge stock of US$ denominated bank deposits thanks to the Oil boom of the past few years. The escalation of petrodollar deposits started to slow even before oil prices began to fall in the late summer of 2006. However, the data does not suggest that the overhang of petrodollar deposits is declining; merely that it is increasing less rapidly than in recent periods of peak accumulation.
• Evidence from security market purchases (look at image below) by oil exporting countries indicates that these countries have been ever-increasing their purchases of US securities in recent months, after decelerating in the second half of 05.
  

• This suggests that fears of diversification by foreign banks, especially petrodollar, holders could weaken the dollar substantially are excessive and less injurious to the dollar than investors may have thought.

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