Tuesday, April 04, 2006

Will Gulf nations diversify away from US dollar?

There has been a good deal of discussion, for some time now, about the desire central banks have to "diversify" out of some of their large dollar holdings. Foreign central banks often hold dollar denominated assets as reserves, and some feel that certain banks may have far too many dollar reserves, given the US government's current financial condition.

It is with this theme in mind that I include today's article from Ame Info. What I liked about this piece was its take on the timing aspect of central bank decisions. It has often been noted that in retrospect, key moves by central banks often come at the exact wrong moment in terms of market advantage. When central banks across the globe were dumping gold in the late 90s and the early part of this decade, their sales actually coincided with the ending stage of the metal's bear market. Could widespread sentiment about the death of the dollar actually signal its return to form, thereby giving central banks a "head fake", or will the the dollar bear market prove to be a lasting trend?

My only quibble with the piece is that its author seems to take solace in the idea that inflation and dollar weakness will be averted by the current cycle of interest rate raising. While quarter point rises in interest rates may lead some to believe that central banks in US and Europe are tightening money conditions, the relationship between inflation and expanding money supply across the globe has gone largely unnoticed. Can "easy money" conditions really turn into tight money while measures of broad money supply show no shortage of money creation across the globe? It will be interesting to see how this plays out over the longer term; that much can be said.

In the meantime, officials from Gulf Cooperation Countries say they will consider moving a sizeable portion of their foreign reserves into euros. Will central banks be rewarded for their trading acumen or simply be duped into favoring one problematic fiat currency over another? Only time will tell.