Will Global Central Banks’ FX Diversification Help the Aussie?

Global central banks are increasingly diversifying their foreign exchange reserves away from the U.S. dollar and the euro, according to latest data from the IMF’s Currency Composition of Foreign Exchange Reserves (COFER), and forex analysts tell CNBC the Australian dollar could be among the main beneficiaries.

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“The reduced attractiveness of the U.S. dollar and euro has led to increased diversification into the ‘other currencies’ such as the Australian Dollar, Canadian Dollar, Swedish Krona and Norwegian Krone,” Barclays Capital said in a note.

Central banks have steadily increased their holdings of “other currencies” — a term used in the COFER to refer to all currencies other than the U.S. dollar, euro, Pound sterling, Japanese yen and Swiss franc — over the past 4 years. In 2011, “other currencies” accounted for almost 12 percent of their portfolios, up from an average of 1-2 percent pre-2008.

“Central banks have been looking for alternative markets since 2008. I believe we will see continued demand for the Australian dollar and Canadian dollar for reserve diversification,” said Jesper Bargmann, Head of G11 Spot FX, Asia Pacific, RBS Global Banking & Markets.

Aussie Dollar a Top Beneficiary

Bargmann says the Australian dollar has become an attractive vehicle for regional central banks looking to increase exposure to Asian currencies.

“To avoid currency restrictions and poor liquidity, the Australian dollar makes a good proxy for exposure to Asia,” he said.

In January this year, Russia expressed its interest in the Australian dollar, when senior central banker, Alexei Ulyukayev, announced plans to start investing some of the country’s foreign currency reserves into the Aussie as early as February 2012.

Simon Derrick, Chief Currency Strategist at Bank of New York Mellon Corp says recent central bank buying of the Australian dollar suggests investors “need to think about it (the currency) in a slightly different light”.

Bargmann believes the Australian dollar offers good value at current levels, noting the 3.4 percent depreciation against the U.S. dollar since February this year.

The Australian dollar has been under pressure in recent weeks on concerns over slower growth in China, its largest trade partner and the world’s top consumer of resources.

“I am looking for the Australian dollar to recover over the next few weeks and I could see it re-test the 30-year highs above 1.10 later in the year,” he said.

Central Banks Dump Euros for Dollars

Data from the COFER also showed that central banks boosted their share of dollar-denominated holdings in the fourth quarter of 2011, while cutting the amount of euros in their portfolios.

“I think the re-allocations reflect reserve managers’ worries over the European sovereign debt crisis. In times of trouble the dollar is still the favored currency - good liquidity and a well functioning bond market becomes increasingly important,” Bargmann said.

Global central banks have gradually shifted out of euro in the recent years. Allocation towards the single currency fell to 23 percent in 2011 after peaking at 34 percent in 2009.

“An increasingly fragmented bond market raises questions over the euro’s status as a reserve currency. This is reflected in the reduced size of flows into the euro over the past few quarters, and in our view this will be a medium-term negative for the currency,” Barclays said.