More news of the coming global economic rebalancing. This time from Morgan Stanley’s chief currency analyst Stephen Jen.
A decline of 1% per year in the USD share of total reserves – which are likely to have breached US$6.0 trillion as I write – translates into US$60 billion worth of currency flows out of USDs. Given that most of the world’s official reserves are invested in only three currencies – USD, EUR, and GBP – the dollar’s loss is the EUR and GBP’s gain. This process has helped explain the structural decline in the dollar in the last three or four years, in our view.
Bad news for US Treasury Secretary Frank Paulson, who at the weekend’s G7 meeting continued to thump the dollar drum: “a strong dollar is in our nation’s interests.”
But it’s not just the dollar which is likely to suffer. Jen also emphasises a shift away from the euro and places the emphasis on emerging market currencies. Accordingly, the shift away from the US dollar is now, more specifically, a shift away from established benchmark currencies as a whole.
As excess official reserves are converted into SWFs, the implications for the currency markets will fundamentally change. Specifically, rather than being essentially a tug-of-war between the USD and the EUR, SWF flows will support EM currencies and the JPY at the expense of both the USD and the EUR, in our opinion. In other words, it is more of a ‘core-versus-periphery’ story rather than a ‘battle-of-the-giants’ story.
To get a sense of how big the currency flows associated with the portfolio rebalancing might be, we computed, based on total AUM of US$3.0 trillion for SWFs, these prospective flows. Specifically, if the SWFs were now to rebalance their portfolios in one go, we would see net USD sales of US$526 billion, net EUR sales worth US$309 billion, net purchases of non-G4 (particularly EM) currencies worth US$451 billion and net purchases of US$306 billion worth of JPY. These are massive flows. As the AUM of SWFs grow over time, the corresponding flows would clearly grow as well.