After a brief pause, the world’s Central Banks (or at least those in Asia) have begun to once again accumulate foreign exchange reserves. I’m not one for hyperbole, but the figures are downright eye-popping: “Reserves held by 11 key Asian central banks totaled $2.625 trillion at the end of August, up from $2.569 trillion at the end of July, according to calculations by Dow Jones Newswires.” Most incredible is that this total doesn’t even include China. whose reserves could exceed $2.3 Trillion by now.

The credit crisis was initially marked by a collapse in trade and an exodus of capital from Asia, as western consumers tightened their wallets and investors flocked to so-called safe havens. As developing countries fought off currency depreciation, forex reserve levels plummeted. Less than a year later, trade has already picked back up, investors have returned en masse to emerging markets, and Central Banks are once again sterilizing capital inflows so as to mitigate upward pressure on their respective currencies. [Chart Below courtesy of Council of Foreign Relations.]

“Taiwan and Thailand, the most aggressive in defending the U.S. currency, have logged record-high reserves every month since December.” Japan, whose reserves are the second highest in the world (after China), is the lone holdout. As the Forex Blog reported yesterday, the newly elected Democratic Party of Japan will pursue an economic policy that depends less on exports, and has pledged to stay out of the forex markets.

The prospects for further reserve accumulation remain reasonably bright, as emerging markets lead the global economy towards recovery. “The outlook for key Asian economies is improving faster than that of developed economies. For the time being, this should accelerate flows into these markets, making it harder for central banks to keep their currencies in check.”

While China’s economy is no exception, its nascent recovery is being driven by capital investment, government spending, and (ultimately?) consumer spending. As a result, it is forecast that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year…that ratio will drop to 24.5%.” If such an outcome obtains, it will almost certainly lead to a slower accumulation of reserves.

While this is all well and good, the more important question for most (forex) analysts is how these reserves are being held. The vast majority of these reserves are still denominated in US Dollar assets, and in fact, the proportion may have risen slightly since the beginning of the credit crisis. Asian Central Banks are particularly biased towards the Dollar, which accounts for 70% of their reserves, compared to the worldwide Central Bank average of 64%.

Moreover, it doesn’t look like plans are afoot to change this trend anytime soon. China has maintained its push (though less vocally) to turn the Chinese Yuan into a global reserve currency, declaring that its capital markets and currency controls will open accordingly to facilitate such. It is in preliminary talks with Thailand for yet another currency swap agreement, to supplement the $95 Billion in such deals signed since December. For its part, the Bank of Thailand has insisted that the Yuan is not even close to challenging the supremacy of the Dollar: “You have to accept that the dollar is going to be a reserve currency for quite some time. You don’t have any alternatives.”

Even China, despite its rhetoric, remains committed to the Dollar. The only talk of diversification in Chinese investment circles is in regards to what kinds of US assets they should invest in, not whether they should be invested in the US or somewhere else. Said the manager of China Investment Corp, which has a mandate to invest nearly $300 Billion of China’s FX reserves, “The risk of a decline in the dollar risks was more of a national issue for China than for CIC because its capital is in dollars.”

This last quote inadvertently confirms that the role of the Dollar as the world’s reserve currency is being treated as a political issue, when in fact it is a financial economic issue. In other words, while many countries want to limit the influence of the US by limiting the power of the Dollar, their Central Banks are stuck with it because it remains the most practical, and advantageous option. Dumping it would be akin to punishing themselves.

In what could be be called an “earth-shattering” election, Japan’s incumbent Liberal Democratic Party (LDP) was finally unseated, after a 50-year stretch in power (excluding an 11-month “hiatus” in 1993). Given both the historic nature of the defeat and the margin of victory, it’s surprising that the election took place with so little fanfare. This is perhaps because the defeat was grounded more in opposition to the LDP than in support for the victorious Democratic Party of Japan (DPJ), of which little is surprisingly known. For that reason, it’s extremely difficult to assess/predict the implications of the election, and I should preface this post by noting how speculative its conclusions are. Still, a few meaningful observations can be made.

First, the DPJ appears to be somewhat liberal when it comes to economic policy. “Yukio Hatoyama, who is poised to be named prime minister, has railed against ‘unrestrained market fundamentalism and financial capitalism.’ ” It’s not clear exactly what was meant by this pronouncement, although it’s certainly connected with the LDP’s pledge to increase spending on social programs: “It says it will improve health care, expand payments for the unemployed and provide a minimum monthly pension…and remove the tuition fees for public high schools of around ¥120,000 a year.”

It also aims to spearhead a change in the structure in Japan’s economy, away from big government projects and export-dependent industries, in favor of consumers and small businesses. Through a combination of tax cuts, transfer payments, and certain spending initiatives, it is intended that consumers will feel a greater sense of financial security, and open up their wallets. “If they succeed, firms that cater to domestic consumers, from clothing retailers to restaurants, are expected to prosper.” Given that the unemployment rate just touched a record low and that deflation has now set in, it certainly has its work cut out for it in this regard.

Second, a crisis is looming in Japan’s public debt, and it’s not clear if/how the DPJ can solve it. The spending measures approved by the LDP while its leaders were still in power are projected to bring Japan’s national debt to 200% of GDP, by far the highest in the industrialized world. Some analysts have ascribed a fiscal hawkishness to the DPJ, and believe that despite its campaign promises, it will actually move to rein in spending.

Other analysts are skeptical, and have argued that unless (consumption) taxes are raised, Japan will soon face a crisis of epic proportions. “We have a government coming in that’s committed to spend even more than the previous government at a time when increased borrowing to spend is just not a plausible option…A catastrophic breakdown of Japan’s public-sector finances will be the biggest story ever to hit the world economy in our times, eclipsing the current financial crisis,” said one economist. Given that the the DPJ has promised not to touch the consumption tax rate for at least four years, such a crisis could come sooner rather than later.

Third, DPJ leadership has pledged not to intervene on behalf of the Japanese Yen, as part of its program to re-structure the economy away from exports. This marks a huge shift from the previous LDP administration, whose policies and rhetoric were consistently geared towards helping exporters and holding down the Yen. “I basically believe that, in principle, it’s not right for the government to intervene in the free-market economy using its money, either in stock or foreign-exchange markets,” declared Hirohisa Fujii, Japan’s soon-to-be-appointed finance minster, who has voiced support for a strong Yen policy on the grounds that it will boost Japanese purchasing power. This contradicts his exchange rate policy during his first stint as finance minister, during which he managed repeated interventions on behalf of the Yen. Still, it should be noted that during his tenure, the Japanese Yen rose against the Dollar.

What do the markets think? The Japanese Yen rose on the news of the DPJ victory, which suggests that investors are inclined to give the new administration the benefit of the doubt when it comes to its pledge not to intervene in forex markets. At the same time, Japanese equities sank, consistent with expectations that the DPJ will be less supportive of big business then its predecessors. In the end, nothing is written in stone, and if the Japanese economy fails to revive, don’t be surprised if the DPJ does an about-face and decides that maybe a weak Yen isn’t so bad after all.

Another Reserve Bank of New Zealand meeting has come and gone.  The verdict: rates will likely be cut no further.  This is according to recent statements made by RBNZ Governor Alan Bollard as the benchmark overnight cash rate was left at a record low.

Stating that economic policy seems stable, along with the current monetary policy, Bollard noted that the central bank will “expect to keep the official cash rate at or below the current level.”

As a result, the recent statements negate indications by the bank in late July that rates may need to move further lower in order to boost adequate economic expansion.  The country itself has been on the recovery, although not as paced as its trading partner Australia.  However, signs are beginning to surface that economic recovery may well help to back current central bank notions.

Recent economic figures point to a more positive GDP outlook as exports picked up in the quarter as imports fell on consumers seemingly turning their backs on foreign made goods.  This turn of events will likely keep the currency supported in recent sessions as traders seem to be taking advantage of the higher yield in an anti-dollar environment.

(Figures taken as of January 2009)

Tonight’s monetary policy outcome is likely to set the stage for further gains in the higher yielding currency pairs as the market now turns its attention to two other central bank announcements.  Both the Monetary Policy Committee and the Bank of Canada are schedule to announce rate moves (or the lack thereof) tomorrow.

Although market participants are already able to tell the future with both banks likely to hold rates steady, currency bulls will be targeting on the accompanying statements.  In regards to the Loonie, it’s a straightforward expectation that commentary on the recent economic expansion and further rate direction will be eyed.  However, Pound bulls will forever be focused on any mention of further quantitative expansion as an increase in asset purchases will further damage the underlying cable currency.

Further directional bias is unlikely to be established as we come towards the end of a shortened trading week.  Rounding out the data ahead of the weekend will likely be a very bland University of Michigan Consumer Sentiment report, anticipated to show a slight pickup in positive sentiment.

Earlier this week, President Obama officially nominated Ben Bernanke to a second four-year term as Chairman of the Federal Reserve Bank’s Board of Governors. The reaction was relatively muted, perhaps because most pundits had already anticipated the news. Bernanke himself probably sealed his own re-appointment with the public relations campaign he embarked on last month, ostensibly to offer a rationale for his response to the credit crisis. “In a profound departure from the central bank’s tradition as an aloof and secretive temple of economic policy, Mr. Bernanke has plunged into the public spotlight to an extent that none of his predecessors would have contemplated.”

Most of the sound-byte reactions came from politicians, and focused on whether he deserved another term, rather than the potential ramifications of his re-nomination. Heavyweights Barney Frank and Christopher Dodd both offered tepid support. Ron Paul referred to the news as irrelevant. Meanwhile, “European Central Bank President Jean-Claude Trichet on Tuesday said he was ‘extremely pleased’ by President Barack Obama’s decision.”

The reactions from investors, likewise, ranged from ambivalent to moderately supportive. Equity markets rose to a 2009 high the day after  the story broke, while the Dollar fell slightly. The re-appointment was deliberately awarded five months ahead of schedule in order to help the president’s credibility with investors. Fortunately (or unfortunately, depending on how you look it), the fact that the markets didn’t react much, shows that they don’t really care. In other words, “President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression” not only because “this remains to be seen,” but also because the ebbs and flows of GDP are contingent on more than just monetary policy.

Regardless of how much credit Bernanke actually deserves, he will certainly have his work cut out for him in his second term. “Bernanke’s Next Tasks Will Be Undoing His First,” encapsulated one headline. At some point, the Fed must raise interest rates, return credit markets to normal functioning, and remove hundreds of billion of dollars from the money supply.

But this is easier said than done: “If the Fed shifts too quickly from the role of savior to that of strict disciplinarian, it risks aborting the recovery and tipping the nation back into a recession, essentially repeating mistakes made in 1937 after the economy had begun to rebound. If the Fed moves too slowly, it risks the kind of intractable inflation it experienced in the 1970s and fueling another bubble.”

The consensus is that, for better or worse, he will err on the side of price stability, perhaps at the expense of economic growth. “A Fed chaired by Ben Bernanke will follow a policy uncomfortably tight as the 2012 election looms into sight. Bernanke has espoused a commitment to low inflation over his entire career,” argued one economist. Meanwhile, the markets aren’t expecting rate hikes at least until 2010, although Bernanke, himself, has conveyed a sense of optimism – and hence hawkishness – about a quick exit from recession.

What does all of this mean for the Dollar? It’s impossible to say exactly, and depends largely on whether Bernanke can unwind the easy money policy of the last year just as deftly as he deployed it.And of course, there is the wild card of the US National debt, and the potential for a loss of confidence to induce a run on the Dollar, which even Bernanke would be powerless to solve.