* Asian central banks' FX reserve accumulation slowing
* Amount to be allocated to euros set to drop further
* Likely to hurt euro and lead to more weakness
By Anirban Nag
LONDON, July 10 Euro weakness could accelerate
in coming months because Asian central banks, amongst the
biggest buyers of the currency in recent years, will have
smaller foreign exchange reserves with which to diversify.
Growth-linked Australian and Canadian dollars could also
weaken as the Asian central banks grapple with capital outflows
caused by a shift in the Federal Reserve's ultra-loose policy.
Until April this year, many Asian central banks were mopping
up capital inflows to keep domestic currencies competitive
against trillions of cheap dollars printed by the Federal
Reserve made their way to Asia and other emerging markets and
bolstered their foreign exchange reserves.
More than half of those were kept as dollars, but a quarter
were recycled and diversified into euros. A smaller proportion
was allocated to the yen, sterling, the Aussie
and Canadian dollars, all which have earned
better returns than the U.S. dollar.
But the tide of inflows has stopped after the Fed signalled
in late May that it was ready to slow its $85-billion-a-month
asset-buying programme, perhaps as early as September.
As a result, U.S. Treasury yields have risen and
dollar-funded carry trades, in which investors borrow in a low
interest-bearing currency to buy riskier and higher-yielding
assets or currencies, are being unwound.
So with capital flows reversing, many Asian central banks
are now selling dollars from their reserves to check a sharp
drop in the value of their currencies. As they draw down
reserves, they will have fewer funds to allocate to euros.
"The more weak growth in reserves we see in Asia, the less
supportive it will be for the euro," said Neil Mellor, currency
strategist at Bank of New York Mellon.
Indeed, the latest data from some of the largest Asian
central banks such as South Korea, Hong Kong, India and
Indonesia with nearly $1 trillion between them, shows foreign
exchange reserves already fell in June from a month earlier.
Accumulation by Taiwan's central bank, another big player
with over $400 billion, has stagnated.
As for China, which has the world's biggest foreign exchange
reserves at over $3 trillion, recent data is unavailable. But
some analysts say with China allowing its yuan currency
to appreciate in recent months, reserve accumulation
due to market intervention may also have slowed.
EURO LOSING OUT
This slowing reserve accumulation may leave the euro without
one of its biggest supporters. Asian central banks have been
steady buyers of the euro, even at the height of the euro zone
debt crisis last year when Greece was close to collapse.
For most of the past decade, the euro has accounted for
more than a quarter of emerging market foreign exchange
reserves, topping at 28 percent in 2009.
But recent data suggests its share could drop below 20
percent, a level last seen in 2001/02.
IMF data released on June 28 shows that of the $11.1
trillion of global foreign exchange reserves, the euro's share
fell to 23.7 percent in the first quarter of this year from 24.2
percent in the previous quarter - the lowest percentage value
since the second quarter of 2004.
At the same time, the dollar's share rose to 62.2 percent
from 61.2 percent.
"In addition to the cyclical justifications for our bullish
dollar view, slower reserve accumulation and diversification
should provide further support for the dollar in the coming
years," said Evan Brown, currency strategist at Morgan Stanley.
It is all down to growth divergence between U.S. economy and
others, notably the euro zone. The Fed is beginning to tighten
while Europe remain in ultra-loose territory.
The euro has lost nearly 3 percent this year as
investors price in more rate cuts by the European Central Bank.
"The recovery in demand for the euro by reserve managers has
been anaemic; net purchases are running at a fourth of the
historical pace even in the face of improved conditions in the
eurozone debt markets," said Kiran Kowshik, strategist at BNP
Paribas. "Diversification away from the dollar is slowing down."