Financial Times Editorial: Dollar dilemma

Dollar dilemma
Financial Times
Published: January 25 2005 02:00 | Last updated: January 25 2005 02:00

The fate of the dollar rests in the hands of a handful of central bankers in Asia. We have known this for some time. Since the foreign private sector shows insufficient appetite for US assets, the US relies on central bank purchases to fund its current account deficit and the acquisition of foreign assets by US residents. By absorbing the excess supply of dollars these central banks stop their own currencies appreciating against it. This Faustian bargain underpins today's currency prices and trade patterns and sustains global imbalances. Any suggestion that foreign central banks may be losing their hunger for dollars is highly significant.

A new survey suggests that central bankers are beginning to ponder whether it is in their interest to carry on buying dollars. This does not signal a rush for the exits. Much of the rise in the share of reserves held in euros is a valuation effect. Two-thirds say they want to keep the proportion in dollars unchanged this year. Neither Japan nor China - which together hold 40 per cent of the world's reserves - took part in the survey. Yet one-third of those polled did indicate a desire to increase the share of reserves held in euros. Eurozone capital markets are seen as liquid. Not a single respondent wants to hold a greater share in dollars.

It would be surprising if central bankers were not thinking very carefully about what they should be doing. The fall in the dollar has already resulted in big capital losses for those holding large dollar reserves. They risk far bigger losses if the so-far steady decline turns into a rout. The importance of capital loss increases as reserves rise relative to gross domestic product. For example, Malaysia's reserves are now equal to 54 per cent of GDP, up from 34 per cent two years ago.

Could a country with a de facto dollar peg diversify its reserves without appreciating against the dollar? Many assume not. In fact the answer, as so often in international economics, depends on whether the country in question is "small" or "large" in this context. A "small country" with medium-sized reserves, such as Thailand, Malaysia or even India, could continue to absorb surplus dollars on the bilateral currency market, but sell its stock of dollars for euros. The effect would mainly be to push the euro up against the dollar. The central bank's own currency could remain pegged.

A "large country" - Japan or China - could also embark on the same strategy. But the scale of the dollar sales would probably cause a generalised dollar collapse, with private buying disappearing altogether, demanding still greater central bank purchases. The central bank would lose control over domestic money supply, resulting in soaring inflation that would in turn push up the real exchange rate. In practical terms, Japan and China probably cannot diversify to a meaningful extent without letting their currencies rise. So keep an eye on the other Asians. Who will break ranks first?

The Prudent Investor says

This “Armageddon” scenario precisely is what I am afraid of. For the Editorial of the Financial Times, which is a mainstream business outfit, to raise this concern simply reflects the gravity of the imbalances. In other words, in the spectrum of risks, this is not an improbable event. This also implies that in such a case where the Central Bank does ‘lose control over money supply’ means that there could be that risk of a ‘crash’ in the US Dollar based currency system. And as to what money system, in its aftermath, the world will adopt remains virtually uncertain. Yet history has shown that under these circumstances, tangible assets will most likely preside as the transition. Hence precious metals today serve as two purposes, one as commodities and most importantly, as an insurance. Profit from folly and not be a part of it!