Euro highly unlikely to dethrone dollar

Dollar is likely to retain its primacy and there is little probability that the euro usurps its role, researchers at Bank of America Merrill Lynch (BAML) said in a recent currency report.

The foreign exchange reserve accumulation and related diversification selling of the US dollar for other G10 currencies by the emerging market central banks was a key factor leading to a downtrend in greenback against other currencies between 2002 and mid-2008 but this dynamic reversed in the autumn of last year, said BAML researchers.

Maintaining a "delicately balanced" outlook for stock diversification of the US dollar, BAML said amid a decline in the confidence in US economic policies, which appears to be a G10 wide phenomenon, foreign exchange reserve portfolios did not appear to be excessively concentrated in the dollar. Besides, availability of a close substitute is limited.

"In particular, the high correlation between euro and emerging markets forex displayed at the height of the crisis and the dis-aggregation of the Eurozone bond market amid high risk aversion have somewhat reduced the probability that the euro usurps the dollar's role.

Overall, recent speculation that major foreign holders of dollar assets are set to liquidate appears overdone. A much greater erosion in policy credibility would be required to jeopardise the role of dollar in financial system," said Daniel Tenengauzer, Head of Foreign Exchange Strategy for BAML.

Expecting that emerging market central banks will not resume meaningful diversification by selling dollars in 2009, BAML estimated reserve accumulation to pick up to $30 billion (Dh110bn) per calendar month. "This puts flow diversification selling of dollar in the region of $10bn per month. This is roughly one-third of its pre-Lehman pace but is significant in the current context of much lower overall foreign exchange volumes."

Assessing current and financial account flows, BAML researchers said the rebalancing of the global economy would have two important implications for reserve accumulation in the emerging world. First, the much reduced US external deficit will result in a slower pace of reserve accumulation and second, the breakdown of the US external trade reveals that the US deficit is roughly evenly split between China and oil producing nations.

"This suggests that steady state reserve accumulation will be dominated by these nations. It also leaves reserve accumulation potentially strongly linked to oil price movements. Our US economy group currently projects a current account deficit of just two per cent of GDP in 2009 and 2010, which is equivalent to a trade deficit of about $20bn per calendar month, which is one-third of peak levels recorded between 2006 and 2008."

Estimating reserve accumulation would therefore be closer to $30bn, putting flow diversification selling of dollar in the region of $10bn per calendar month, BAML projected portfolio capital inflows to Merrill Lynch's Emerging Markets50 (EM5) index run at around $10bn per calendar month with net foreign direct investment running at $7bn per calendar month.

"Added to the monthly US trade deficit this would suggest $37bn per calendar month of net private sector demand for emerging markets foreign exchange. For this to translate fully into reserve accumulation, emerging market forex rates must reach levels that trigger determined resistance to further appreciation by local central banks. This is clearly the case for the pegged currencies. These currencies are also the most relevant in terms of lingering trade imbalances given that the US monthly trade deficit now divides almost equally between China and oil-producing nations."

The report said that the lower bound of monthly reserve accumulation was likely to equal the US trade deficit, raising the observation that the proportion of China and oil-producer nations foreign exchange reserves maintained in dollar equated to the proportion of the US deficit that is automatically financed.

"In terms of a central estimate of reserve accumulation, a haircut should be applied to the net private sector demand estimate $37bn per month, as we would expect some emerging markets central banks to allow further forex appreciation," the report said.

The researchers said that the recent rally in emerging markets foreign exchange had "prompted sporadic intervention to buy US currency versus local currency from a broad range of central banks".

They said reserve accumulation appeared to be picking up from the previous low levels. Quoting its Tracking Reserve Accumulation and Diversification (Trade) Metric, BAML said it suggested EM50 forex reserve growth of around $140bn during May.

"With forex volumes from other customer segments sharply down, this scale of order flow could now have a larger influence than it has done historically.

Nevertheless, there are reasons to be sceptical that this rate of reserve accumulation – which is effectively at the upper bound of what we think we can sustained this year – and subsequent diversification selling of dollars for other G10 currencies will continue. "

The report said that the focus in emerging markets appeared to be shifting to a more domestic demand-led growth strategy."

Keep up with the latest business news from the region with the daily Emirates Business 24|7 newsletter. To subscribe to the newsletter, please click here.

Follow Emirates 24|7 on Google News.