A recent survey shows that many countries’ central banks are reducing their US dollar holdings in favour of the euro.

This trend will hinder the US government’s ability to finance future current account deficits, and will likely push the dollar’s value to decline even further relative to the euro.

The survey—sponsored by the Royal Bank of Scotland Group Plc., the UK’s second-largest lender, and conducted by the Central Banking Publications Ltd., a London-based publisher—was conducted between September and December of 2004 and published in mid-January 2005.

More than 66 percent of the 56 central banks surveyed prefer the euro to the dollar or find the euro and dollar equally important. The International Monetary Fund had already publicly recognized this shift from the dollar to the euro over the past three years.

Close to 52 percent of the central banks surveyed had already realigned their reserves more closely with the euro over the past two years, while less than 27 percent had realigned their reserves closer to the US dollar. The British pound was also a winner, as 40 percent increased their British pound reserves. Around 29 percent reduced their exposure to the Japanese yen, while 11 percent increased their yen reserve holdings.

The dollar’s outlook does not look promising. Surveyed central banks agree that reserve holdings will increase in the future, but less rapidly. Reserve holdings in mid-2004 were around US$3.8 trillion and rose at an average rate of 66 percent over the past forty-two months. Predictions see an almost 40-percent slowdown over the next three years to around US$5 trillion in 2008.

Central bank acquisition of US securities financed more than two-thirds of the US account deficit. A commonly held belief is that the United States can no longer depend so heavily on this source for financing its account deficit.

Close to 100 percent of the central bank reserve administrators acknowledged the importance of prudent reserve management. Diversification—holding a portfolio of several currencies—is the new trend.

One slight relief for the US is the People’s Bank of China’s announcement that it will maintain its reserves in US dollars, but it is rumoured that it has done some quiet shopping and might also shift towards other currencies, though at a slower pace than other banks’. The Chinese announced that they had increased their dollar reserves by US$207 billion in 2004.

Japan, the leading holder of US treasuries, held just over US$400 billion at the end of 2004. Tokyo is tight-lipped about Japan’s future reserve plans.

Alexei Ulyukayev, First Deputy Chairman of Russia’s Central Bank, is feeling the heat and seriously contemplating aligning Russia’s reserves more closely to the euro. At present, Russia’s reserves are mostly in US dollars.

Members of the Organization of the Petroleum-Exporting Countries (OPEC) have cut their reserve dependency on the dollar from 75 percent to 62 percent over the past three years.

The Bank of Thailand stated that it will likely decrease its US reserve holdings from 80 percent to 50 percent.

The US was forewarned. In November 2004, Alan Greenspan let it be known that the country could no longer rely on foreign governments to finance its current account deficit.

Instead, the US must find new ways to fund its ballooning account deficit. No solution is yet in sight.