Should GCC states diversify reserves away from the US dollar?

Some commentators note that by the time a central bank decides to make a move that time has probably past. Ergo The Bank of England sold its gold reserves a few years ago just as the gold price hit rock bottom, and so too did the UAE.

On this logic the discussion among GCC central banks about diversifying away from the US dollar comes at a time when the greenback has already devalued significantly against the euro, which is currently worth $1.21 compared with 85 cents at its low point. So is this yet another example of central banks trying to close the door after the horse has bolted?

Reading the future in currency markets is a fool's errand, but that is what central bankers are forced to do by the very nature of their job. And there is a very powerful argument that suggests the US dollar is in a long-term cycle of decline in value, linked to the twin trade and current account deficits.

Debt signals devaluation

In short, the US is deeply mired in debt, to the tune of 6% of GDP while a figure in excess of 3% would usually be a signal for currency devaluation. Thus a rebalancing through devaluation looks on the cards.

The problem is that as the global reserve currency the US dollar does not always behave as economic theory suggests it should do. In particular the holding of large Treasury bond positions by foreign powers, whether in China, Russia or the Middle East, supports the currency at present value.

Besides rebalancing through devaluation is not the only way that the deficits can be cured. An alternative would be a US recession that cut spending on imports, for example, and resulted in a sell-off of US assets and a flight to the US dollar as a safe haven asset. Indeed, the latter shift of investors into cash would tend to strengthen and not weaken the US currency.

US dollar to rally?

So if the present five-year high in equity markets also proved to be a high in the business cycle, and tipped over into a stock market sell-off then the US currency might well rally strongly. And then a central bank that had bought euros or yen might be left wishing that it had stuck to the greenback.

The same could also be said of diversification into gold. With gold up from $300 to almost $600 at the time of writing, shifting some of a country's reserves into gold might appear a no-brainer. But in a worldwide asset sell-off, investors would also be forced to sell gold to cover positions in declining markets and the yellow metal would fall in value along with everything else.

This is not to say that the new US Federal Reserve Chairman Ben Bernanke would not fulfill his promise of showering the US economy with money to protect it from deflation, and thereby devalue the US dollar.

But let us not forget that inflation is the enemy of the hour and tightening US interest rates is what is actually happening right now, and that is surely a positive and not a negative for the US dollar.