LONDON-BASED EXPERTS AGREE THE U.S. DOLLAR WILL

C O N F I D E N T I A L SECTION 01 OF 03 LONDON 001451

NOFORN
SIPDIS

E.O. 12958: DECL: 06/19/2019
TAGS: EFIN ECON UK
SUBJECT: LONDON-BASED EXPERTS AGREE THE U.S. DOLLAR WILL
MAINTAIN ITS RESERVE STATUS

REF: LONDON 1399


1. (C/NF) SUMMARY: Despite the decline in the dollar share of
global FX reserves over the past decade and recent debates on
the creation of a new global reserve currency, the U.S.
dollar's reserve status remains in-tact. Gains made by its
nearest rivals--the euro, pound sterling, and yen--over the
same period have not come at the expense of the dollar.
Currency experts at HSBC and Deutsche Bank stressed to
ECONOFFs during recent meetings the dollar's principal
reserve position took time to build up and would require a
long time to change. They agreed recent proposals to make
the SDR a global reserve currency lacked viability. The
dollar's trend decline, coupled with smaller developed
currencies as well as emerging market currencies gaining
importance, suggested greater diversification in terms of
currency composition of central bank holdings instead of full
displacement of the dollar. Longer term, an economic order
based on a multiple reserve currency system is a possibility.
End Summary.


Consensus on Dollar Maintaining Reserve Currency Status
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2. (C/NF) Along with other London-based financial experts
(reftel London 1399),senior currency strategists agree the
replacement of the dollar as the global reserve currency is
unlikely. During meetings on June 16 with ECONOFFs, both
David Bloom of HSBC and Henrik Gullberg of Deutsche Bank
cited that IMF data on FX reserves indicated the dollar
maintained a significant share of world reserves by a large
margin from 2001 to 2008 and noted, more importantly, the
data captured changes in FX reserve composition by central
banks during a period of intense financial market volatility
and when some central banks intervened to support their
domestic currencies. Both FX experts maintained the dollar's
nearest rivals--the euro, pound sterling, and yen--failed to
gain significant ground over the same period. The dollar
share of total holdings of FX reserves fell from 71.5 percent
in 2001 to 64 percent in the final quarter of 2008 but still
accounted for more than twice the euro holdings, sixteen
times more than pound sterling holdings, and twenty times
more than yen holdings. Put simply, Bloom told us, the
decision to hold a reserve currency is a very political
decision; central banks consider the economic and political
influence of a country and also its political and default
risks. At the end of the day, Bloom said, people still want
their long-term investments, such as pension funds, invested
in dollars because the U.S. provides the safest investment.
Gullberg noted Bank of Qternational Settlements (BIS) data
on FX turnover, albeit lagged, revealed some smaller
developed currencies--Australian and New Zealand dollar and
the Swedish krona--as well as some emerging currencies--the
Hong Kong dollar and Polish Zloty, for example--have
increased in importance, though from a low level. Given
currencies, rankings as official reserves typically parallel
their status in international trade, this development might
mean official reserves also will become more diversified says
Gullberg; but it does not suggest displacement of the dollar.


3. (C/NF) In their May 2009 Currency Outlook, HSBC analysts
argue even if the world continues to switch from the dollar
to the euro at the rate of one percent per year, it would
take 30 years for the two currencies to be held in equal
proportions. For the euro or one of the dollar's nearest
rivals to overtake the it as the main reserve currency, a
significant number of changes would need to take place; in
particular, there would have to be some material loss of
confidence in the dollar as a store of value and a loss of
confidence in the U.S. economy. Gullberg also stressed to us
the euro was still a "fresh experiment" and problems in
peripheral euro-area countries may drag it down.


4. (C/NF) Gullberg told us the longer term risk to the
dollar's reserve status is inflation--more specifically if
the U.S. faces sustained high inflation relative to other
major economies, market and trade participants might be
tempted to use another store of value. However, he stressed
there has been no real evidence of inflation risk. Recent
talk about exit strategies suggest the Federal Reserve and
other central banks are aware of the longer-term inflationary
consequences of running an expansionary policy for too long.

Special Drawing Right (SDR) Proposals Lack Credibility
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5. (C/NF) During the meeting with ECONOFFs, Bloom called
discussions of the SDR as a reserve currency fanciful. He
argued while some G20 members have raised the idea of
replacing the dollar with the SDR, actual implementation
would be incredibly complicated and therefore, he attached
extremely low probability to the switch. He viewed the
recent SDR proposals as political posturing rather than
financial reality. In practical terms, it is difficult to
suddenly and dramatically change the status quo of reserve
ownership, he said. Gullberg also questioned the credibility
of discussions of changing the SDR basket. He asserted a
basket which included the Russian ruble and Chinese yuan
would add to appreciation pressure, at the margin, on their
own currencies because countries would be accumulating each
others' currency. Currently the SDR's exchange rate is
determined by a basket of currencies that include the dollar,
yen, and pound sterling. The IMF is expected to review the
basket in November 2010. (Comment: According to press
reports, President Dmitry Medvedev recently urged the IMF to
expand the currency basket of SDRs to include the Chinese
yuan, commodity currencies, and gold as part of the process
of the SDR maturing into a reserve currency.)


6. (C/NF) If the SDR became the world's reserve currency, the
composition of reserves would have to change materially says
Bloom. Using the current dollar share as a starting point,
HSBC analysts in their May 2009 currency outlook, posit
shifting the 64 percent to an SDR proportion of dollars at
the current exchange rate would mean central banks would have
to cut the weight of the dollar by 22 percent, i.e. sell
roughly 1.5 trillion dollars, assuming central banks hold 4.3
trillion of dollars in reserves now. (Comment: The SDR is
comprised of fixed currency amounts, not fixed currency
weights and the currency weights change on a daily basis
because the value of the currencies within the SDR change.
The IMF reviews the currency amounts every five years.) The
sale would be made up by the ownership of the euro, yen, and
pound sterling. As the fixed dollar amounts remain unchanged
in the SDR, one would have to sell more dollars as the dollar
fell in value. If the shift to the SDR precipitated a 20
percent drop in the dollar's value, the amount of dollars
sold would have to rise to $2.5 trillion because of the
falling weight of the dollar in the SDR as the dollar
depreciates. Using this example, analysts argue the reality
of a shift away from the U.S. dollar is implausible.

Jawboning by Russian officials?
--------------


7. (C/NF) Timothy Ash, Head of CEEMEA Research at the Royal
Bank of Scotland, commented about mixed signals from
policymakers in Russia on Moscow's developing alternative
reserve currencies in his June 16 report. He maintained
Russian officials had been pushing for alternatives to the
dollar as the global reserve currency for months, in part to
use the global financial crisis as a means to further
challenge the U.S. global hegemony since the collapse of the
Soviet Union in the early 1990s. Recent comments by Russian
Finance Minister Kudrin suggesting the dollar's dominance as
the global reserve currency would remain for some time and
the dollar's fundamentals were still "fine" potentially
implied a change of tack from Moscow. However, Ash argued
Russian President Medvedev and Senior economic advisor Arkady
Dvorkovich appeared to distance themselves from Kudrin,s
remarks and suggested the long-term goal was still to
diversify the range of global reserve currencies. Ash
contends the jawboning by Russian officials has refocused
market and broader political attention on the BRIC summit and
underscored Russian and BRIC influence over bigger picture
dollar trends. Russia's mission remains to push forward
alternatives to the majors as reserve currencies.

World of Multiple Reserve Currencies A Possibility, Down the
Road
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8. (C/NF) While the SDR proposal may seem implausible, Bloom
sees the potential in the distant future, with open markets,
of a multiple reserve currency system with the dollar, euro
and Chinese yuan sharing reserve currency status. There
would naturally be winners and losers in such a system with
the single reserve currency losing some status relative to
the new entrants but it would not imply full displacement of
the previous single reserve currency (i.e. the U.S. dollar).
Bloom likened the debate to the one on which would become a
bigger financial center--Hong Kong or Singapore. He argued
history has proven there is room for both; therefore a world

LONDON 00001451 003 OF 003


with multiple reserve currencies is possible if critical mass
in markets creates the environment. Gullberg, however,
argues a multiple reserve currency scheme takes away the
benefit of having a reserve currency in the first place.
Professor Danny Quah of the London School of Economics
suggested to us during a June 16 meeting that China may not
be ready to have the yuan serve as an international reserve
currency and highlighted the concerns about China's currency
appreciating too quickly. Despite talk about boosting
domestic demand, China remains an export-led economy; a rapid
appreciation would lead to a loss in export competitiveness.
As a holder of $700 billion of U.S. debt, rapid appreciation
would yield 25 percent loss in real wealth.

Mixed Views on Chinese Efforts to Promote Yuan
Internationalization
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9. (C/NF) Experts are divided on the effectiveness of Chinese
efforts to promote the use of the yuan internationally.
Professor Quah posited recent efforts to promote yuan use
regionally were a good "testing the water" step for greater
international usage. China's trade with East and Southeast
Asia is double that with the West so settling transactions in
the yuan may help relieve pressure within the region.
Gullberg, on the other hand, calls Chinese efforts to use the
yuan in trade unrealistic and was not confident its trade
partners would sign on to conduct transactions in it. HSBC
analysts, in their May 2009 outlook, noted widespread take up
of the option to settle in yuan would depend on the specifics
of the policy. Pent-up demand among Hong Kong firms whose
main business is centered on the mainland should give the
scheme some critical mass at early stages. Firms conducting
international trade are likely to be more worried about the
risk management flexibility that comes with the currency
denomination; consequently, the regulations will need to
offer some reasonable degree of yuan convertibility to make
it sustainably attractive.



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