US Dollar
More bad news for the dollar – this time from sovereign funds
The weak US economy and falling US dollar have prompted sovereign wealth funds to consider reducing their exposure to the US dollar. Both Gulf countries, and China, have already started this process, and the Russian Central Bank has also been gradually reducing its exposure to the US dollar.
According to an article by Henny Sender in New York, published in the Financial Times, one big sovereign fund in the Gulf has cut its dollar denominated holdings from more than 80 per cent a year ago, to less than 60 per cent. In addition, China's State Administration of Foreign Exchange has been looking to strike deals with private equity firms in Europe, to reduce its dollar holdings. Sovereign wealth funds, according to the article, have suffered in their attempts to recapitalise faltering US banks and appear to have lost their appetites for the greenback.
The Gulf States, in all likelihood, will continue to support the US dollar and, therefore, a wholesale reduction is unlikely; for instance, the Abu Dhabi Investment Authority (ADIA) has remained faithful to the dollar, despite concerns over rising inflation due to their currency peg to the dollar. Similar to the United Arab Emirates (UAE), of which Abu Dhabi is the capital, Saudi Arabia also has its currency pegged to the US dollar. Currency pegs have effectively imported inflation to the Gulf region.
Given the poor performance of the US economy, and the dollar’s weakness against all major currencies, measures to reduce the US dollar are widely expected. The most likely scenario will be countries and sovereign funds switching to a currency basket, thus enabling money managers to invest in assets denominated in other currencies.
A significant reduction in US dollar exposure by China's State Administration of Foreign Exchange (SAFE) may prove to be devastating, as it manages the bulk of the country's fast-growing foreign currency reserves. SAFE is alleged to be encouraging private equity firms with which it has relationships to make investments in natural resources companies in markets outside the US, in order to hedge its exposure to the dollar.
In addition to funds held by SAFE, China also has a state owned $200 billion sovereign wealth fund, China Investment Corp, whose objective is to earn greater returns on its foreign exchange reserves; these reserves were estimated to have reached US$1.81 trillion by June 30, 2008, recording a staggering 35.7% year on year increase. According to the People's Bank of China, foreign exchange reserves increased by $280.6 billion in the first half of this year. With mounting foreign reserves still largely denominated in US dollars, China’s currency policy could play a significant role in the US dollar future.
Other countries that are cutting their exposure to the US dollar include Qatar and Russia. Qatar has reduced its exposure by approximately 60%, distributing its funds between the US dollar (40%), Euro (40%) and an assortment of other currencies such as Yen, Sterling etc (the remaining 20%). Russia has also been gradually diversifying away from the dollar, and now has just under half of its reserves in dollar denominated instruments. The Russian Central Bank expectes the US dollar portion to fall to 45%.
So the US dollar is on shaky ground. A weaker dollar usually means underperforming US stock markets and high inflation; gold and precious metal stocks may benefit in that environment as investors seek to hedge against inflation.
The US dollar’s strength now depends on the continued support of big backers such as the Abu Dhabi Investment Authority. Most of the major oil producing countries continue to remain loyal to the US dollar; for instance, the three largest sovereign wealth funds are owned by oil producing countries and (apart from occasional grumblings) they have been long term friends of the US dollar. Whilst both Russia and China have large sovereign funds, they have already reduced their exposure, and so further wholesale reductions in exposure to the US dollar are unlikely- at this time.