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Catching a Falling Financial Knife

More Central Banks diversify away from the US Dollar- Forex Crises to follow

Currencies / Analysis & Strategy Mar 06, 2007 - 10:51 AM GMT

By: Julian_DW_Phillips

Currencies

For years now we have warned of tsunami like capital waves crossing the globe bringing financial drama with it. We have pointed to the structural problems that could give rise to the damage these waves will cause. We have warned of the Central Bank's moves away from the U.S.$. We have also warned of the damage the Trade deficit is doing to the U.S. We have also warned of global foreign exchange and rates crises.

We coined the expression "Live now, Pay later" syndrome that has been all-pervasive in the U.S.A. Add this to the "so far, so good" attitude and what happened this week in global markets has been long overdue. It signals that globalization and the free flow of capital across this globe of managed foreign exchange rates, plus the interdependency of global economies will undermine all paper currencies to some extent. This week saw that begin . Probably a group of global funds thought the time was ripe in many markets to rattle some cages and down the markets went. That they should have this ability and power is the frightening thing and the situation can only worsen as other speculators and fund powerhouses get the scent of this action.


Many have touted a collapse in the $, but we say that this is not a necessity for a rise in the gold and silver prices to take place. A drop in the level of confidence in the U.S. unit is all that is necessary. Well we are seeing that in the globe's foremost of financial institutions, the Central Banks as of now. Whither they go, go us.

Central banks are, across a broad front, increasingly diversifying their reserves, including cutting holdings of the U.S. $. Italy, Russia, Sweden and Switzerland have made "major adjustments" in foreign-exchange holdings favoring the € and the Pound Sterling between September and December 2006. Central banks are open to saying they've been diversifying to improve returns and reduce exposure to any single currency, which means, selling the $.

And the U.S. is not helping itself either because last month saw the Capital account fail to support the Trade deficit in January. If this continues, that alone could drop the $ like a stone. After all, the U.S. has become utterly dependent on the Capital account to fund the Trade deficit as it reaches new record levels every year.

The $ accounted for 65.6% of the world's currency reserves in the third quarter of 2006, down from a peak of 76%, according to the International Monetary Fund.

Two Central Bank surveys were done recently looking at the extent of $ diversification, here are the conclusions of one [very similar to the other]:

Central Banking Survey .

  • The respondents in this confidential survey don't include the People's Bank of China or the Bank of Japan , which together hold the world's largest foreign exchange reserves [they account for 30% of total reserves held worldwide, or $1.5 trillion].

  • Of the 47 central banks that responded by December to the survey, 21 of them, managing reserves of $630 billion, said they had increased the share of their reserves held in the €, and 15 of those said they had done so at the expense of the $.

  • The survey showed that seven central banks said they had cut the share of reserves held in the €.

  • Nineteen central banks said they had cut the share of reserves held in the U.S.$, while only 10 had increased the share of reserves held in the $. Only five of the latter group, with reserves totaling $70 billion, said they had done so at the expense of the €.

  • Nine central banks raised the pound's allocation, while four cut its share of reserves.

  • Four central banks reported cutting their allocations of the Swiss franc, and none reported increasing its share.

  • Six central banks said they had raised their yen allocations, while four cut their allocations to the Japanese currency.

  • The shift into the € on the scale suggested by the survey would still leave the $ as the dominant reserve currency by a large margin. The International Monetary Fund has said that in the third quarter of 2006 the $ accounted for 66% of foreign currency reserves, while the €, accounted for 25%. In the second quarter, the $ accounted for 65% of reserves, and the € 25.5%. [This is a small change in terms of the risks to the $.]

  • Central banks are still investing in riskier assets as they chase greater returns on yields. 69% said they were looking for more yield, having been forced to widen their asset range by a low-yielding environment. More than half of the respondents said there is scope for central banks to diversify beyond traditional assets into equities, and around a third said banks should invest in commodities.

  • After a long decline as a reserve asset, the survey indicated that gold may be about to make a comeback. Some 63% of central banks said gold had become more attractive following recent price rises and an increase in market liquidity. But gold's role as a safe haven in the wake of natural or man-made disasters is also part of its attraction for central bankers .

Please note that not one of these banks have stated they no longer want to hold the U.S.$, because of the risks to its value. We do not believe this is their major consideration. Why, because all currencies are interdependent and one currency cannot divorce itself from another, so long as the pattern of international trade is as it is. They are fused together. Ideally they only have to target inflation to maintain price stability. Exchange rates are not an issue in the main global blocs, such as the U.S. in the eyes of the Central Banks. Ideally they would want fixed exchange rates to stabilize global trade.

Alas, the Central Banks have no option but to switch to other currencies to improve their reserves, because of the sheer volume of their holdings of the $. Gold or silver or other commodities just could not accommodate their demand, unless the metal prices had an additional nought at least, on the end of them. [Huge stockpiles of oil could be a way to go, but storage facilities have to be built to accommodate this.]

But with such diversification added to the efforts of China in moving away from the $, the present levels of exchange rate values will just not hold in a $ crisis and it is naïve to think they will. But then again where else can they go? It is only fair to say that Central Bankers ignore exchange rate moves in their decision-making regarding currency holdings. Yes, they differentiate between 'soft' and 'hard' currencies, but yield has to be the main criteria .

So the vulnerability of the $ grows by the day.

The bottom line is this, there is no true haven from the $ in other currencies. In a crisis they will try to cling to each other, with some being forced to lower or raise their exchange rates with important trading partners. But essentially they are all in the same boat together.

But where a national economy's health is dictated by exports, Central Bank will intervene to ensure trade competitiveness is ensured [e.g. Japan or India]. As we watch many Central Banks intervene in their exchange rates in this way in the future, we will see many currencies falling with the $ encouraging capital flows to grow even larger as they used to in the days of fixed rates in the foreign exchanges. As we point out weekly, currencies relate to one of the main three trading blocs of the world and attempt to keep their exchange rate in line with that one. For instance South Africa's main trading partner is Europe, Australia's is China, hence the exchange rates moves we are seeing now. So the world's most important exchange rate is the $:€.

So Central Banks want stable exchange rates and do intervene. This is like a red rag to a bull to speculators. With Central Banks holding together the foreign exchanges of the world, Capital flows will find little to prevent them from going where they want to. Another feature of global markets that we have been highlighting is the concept of, "He who sows the wind reaps the whirlwind." As Central Banks try to hold the system of exchange rates together with as little rupture as possible [as we have seen in the last few years], so they will fall foul of the Capital flows flooding across borders to greener pastures, pressing Central Banks as in the past, but with greater power than ever before.

We have heard it said that switching out of major currency holdings is easy, for Central Banks, they just enter the foreign exchange markets and sell what they receive. To say that is naïve, because like any market, if supply is heavier than demand, prices will fall. With so many diversifying from the $, the growing overhang is finding nowhere to go, except home. The continuous outflow of the $ is gradually oversupplying an unwilling market. It takes little to understand the interest rates alongside the $ exchange rate has to go down, not in a controllable way, but in the face of a future tide of U.S. $'s coming home. We have in the past mentioned Capital Controls are a possibility at some stage in the States, to hold back this flood from damaging the internal economy through inflation, against a backdrop of deflation in many areas of the economy [but not all].

But a consequential collateral damage will be to the nations holding onto their exchange rates with the $. They will have to revalue , or let their exchange rates rise, if their economies are dependent on the U.S. This will weaken them internationally. Those dependent on the Eurozone or on Asia for their international trade will however, rise out the $ storm.

But, 'hot money' now called the 'carry trade' will look, along with the hedge funds and the newly born George Soros', will be there to push exchange rates the way they should go and maximize their impact and profit from any resistance in their way. The result will be to drive all types of solid Investors to safe havens, including gold silver and whatever else holds value in these days.

The development of the Internet, the knowledge revolution, as well as other aspects of the information and communication revolutions will add "moments of force" [weight added to momentum] to the capital flows that will shake weakened economies, prompting protective action like exchange controls or Capital controls from wreaking havoc with these Central Banks. The memory of George Soros, breaking the Bank of England and making one billion pounds profit overnight, is well remembered amongst Central Banks.

At Gold & Silver Forecaster we expect the world's currency system to move closer to a series of major crises, quicker than before and accelerating as it goes. We will continue to focus on the external developments that influence gold and silver prices as well as the simple gold and silver market factors. We see investment demand growing as a price influence as we progress down this road. We are led to believe that we are the only such letter with this perspective and who cover the monetary aspect in this way. Therefore we have to emphasize that it is this influence on gold that will drive the gold and silver prices to new heights, as investment demand grows. Keep in touch with us closely, so we can help you really benefit from these markets . We are a "must have" newsletter alongside others.

Last week's global markets pullback was merely a taste of what is to come. The flow of money was not just market driven, it was driven by funds large enough to rock global markets. And let's be clear about one fact in these markets, it does not take a collapse of the $ or any other currency to make gold and silver an attractive investment, just the fear of one . This fear and uncertainty will grow in the months and years to come making the flow of investment funds into gold a steady feature until its price will inspire confidence and consequently the currency of the holders.

Please subscribe to www.GoldForecaster.com for the entire report.

By Julian D. W. Phillips
Gold-Authentic Money

Copyright 2007 Authentic Money. All Rights Reserved.
Julian Phillips - was receiving his qualifications to join the London Stock Exchange. He was already deeply immersed in the currency turmoil engulfing world in 1970 and the Institutional Gold Markets, and writing for magazines such as "Accountancy" and the "International Currency Review" He still writes for the ICR.

What is Gold-Authentic Money all about ? Our business is GOLD! Whether it be trends, charts, reports or other factors that have bearing on the price of gold, our aim is to enable you to understand and profit from the Gold Market.

Disclaimer - This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold-Authentic Money / Julian D. W. Phillips, have based this document on information obtained from sources it believes to be reliable but which it has not independently verified; Gold-Authentic Money / Julian D. W. Phillips make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold-Authentic Money / Julian D. W. Phillips only and are subject to change without notice.


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Catching a Falling Financial Knife