Goldman Sachs gave an account of the first formal BRIC summit that was held last June 2009 to reflect on the outlook of the US dollar as the primary reserve currency. Back then, China’s central bank governor ordered for the creation of a new reserve currency. The governor indicated in a parper published on the PBoC’s website: “The world needs a new ‘super-sovereign reserve currency’ to replace the current reliance on the dollar”. Meanwhile Russian President Medvedev likewise made a statement, “We have to consolidate the international monetary system, not only through the consolidation of the dollar but the creation of new reserve currencies.”
This confusion in the USD had manifested earlier. The global financial crisis started the forex calendar with a credit crunch in the US. Some trillion USD in reserve-related inflows anchored the US fixed income market and then left the central banks with large exposures to the US capacity to pay for its debts, prior to five to six years when the global financial crisis occurred. The Fed had tripled the magnitude of the first Quantitative Easing program that was announced in November 2008, which is precisely three months before the first BRIC summit in March 2009. This trend is concerned with the BRIC central banks which was tantamount to monetisation of US government debt.
Trade Weighted USD
The trade-weighted USD fell by nearly 10% during the 2009 summit and continued to depreciate by another 5% towards the end of the forex calendar year. The EUR/USD rallied from 1.25 to greater than 1.55 in the same forex calendar. The Summit concluded without any declaration regarding reserve currencies. Forex news at such time revealed that the Chinese delegation was concerned on the effect on its existing USD reserves.
IMF COFER data on allocated FX reserves shows that EM central banks accumulated only about $10.7bn of additional USD reserves in Q2 2009, while EUR reserves increased by $44.3bn during the same quarter. The share of USD holdings dropped quite sharply from 61.2% of all allocated EM reserves at the end of March 2009 to 57.8% at the end of September.
Revival of Talks
Goldman Sachs reported that the holdings of Euro-denominated reserves have increased once more. On one hand the USD reserves are near again at 61% of total allocation. The Fed likewise surprised on the dovish territory again by postponing its tapering of asset purchases in conjunction to earlier indications during the recent forex calendar weeks. In the meantime, China’s official Xinhua News Agency published yesterday a critical commentary on the current US situation: “The cyclical stagnation in Washington for a viable bipartisan solution over a federal budget and an approval for raising the debt ceiling has again left many nations’ tremendous dollar assets in jeopardy ….” The piece concludes: “What may also be included as a key part of an effective reform is the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.”
The broker further detailed that the biggest beneficiary of such an allocation shift would likely be the EUR, in which EM central banks currently hold less than 24% of their reserves. Arguably the post-crisis Euro area is in a much stronger position to assume a bigger reserve currency role. The US budget deficit remains almost twice as large as the Euro area’s (5.8% versus 3.1%, according to the latest IMF Fiscal Monitor). The cyclically adjusted primary balance in the US is still at a deficit of 1.9% of GDP, whereas the Euro area records a surplus of 1.1% of GDP. The current account gap at 2.5% of GDP in the US contrasts with a similarly sized surplus in the Euro area. Moreover, the Euro area is making steady progress with key financial reforms such as the Banking Union and imposes much tighter rules to coordinate fiscal policy for the individual Euro area member countries than before the crisis.
Growth in the US certainly remains faster than in the Euro area, but the steady recovery since the second quarter has also narrowed the growth differential.
The fundamental case for the extremely high allocation to USD-denominated reserves has become weaker and the Chinese comments suggest the issue is entering the public debate in countries with very large FX reserves. And this time round the EUR may offer a better alternative than in 2009; in addition, the current allocation to EUR is far lower.
Goldman Sachs continue to expect the EUR to rally towards the end of the forex calendar year, in particular against the USD.
Goldman Sachs has recommended the following FX trades:
(1) Stay long position EUR/INR 6-month forward, opened at 84.56 (on a spot basis) on 30 Sep 2013, with a target of 92.00 and a stop on a close below 82.00 (on a spot basis), currently at 83.50.
(2) Stay short position USD/JPY, opened at 97.2 (on a spot basis) on 3 Oct 2013, with a target of 94 and a stop on a close above 98.8 (on a spot basis), currently at 98.42.