Financial Times Editorial: Dollar scare reveals fragile support

Dollar scare reveals fragile support
Published: February 24 2005 02:00 | Last updated: February 24 2005 02:00
Financial Times

Crisis over? Not really. For sure, the market overreacted to reports that the Bank of Korea wanted to reduce the share of dollars in its portfolio. What the Koreans actually said was that they want to diversify out of low-yielding US Treasuries into higher yielding securities, which could include riskier US assets as well as non-US government bonds. And they intend to do so by diversifying the flow of reserves, not the $200bn (£105bn) stock. But while Tuesday's sell-off was founded on error, it nonetheless exposed the underlying weakness of the US currency. If the mighty dollar can be rocked by a single paragraph in a report to the Korean parliament something is amiss.

That something is the dependence of the dollar on a handful of Asian central banks, which between them control $2,400bn reserves. These reserves are already large relative to the size of the Asian economies, and getting bigger by the day. As they grow so does the incentive to guard against capital loss from further dollar depreciation.

Very obviously, if all the Asian central banks were to start selling their stock of dollars the US currency would plunge. But such a generalised rout would also force the Asian currencies to appreciate against the dollar. If either Japan or China were to sell dollars, the effect would probably be the same. However, the first mid-sized country to bail out of the dollar might be able to get a good price for its assets and maintain its bilateral exchange rate, encouraging others to follow.

But even if Asian central banks do not sell their stock of dollars, the US currency is not safe. With private appetite for US assets inadequate and volatile, the US relies on continued purchases by central banks to fund its current account deficit and acquisition of foreign assets by US residents. If their appetite dims, unless private flows soar, the dollar will still fall (and keep on doing so until the change in the relative price of imports and exports narrows the current account deficit to a sustainable level.)

Diversification might not succeed in its objective of minimising capital loss. It all depends on what currency one diversifies into. The euro is no longer obviously cheap. If and when Asia revalues the euro could even fall against the dollar. In this case the capital loss would be greater on euro holdings than on dollars. Asian countries need more Asian assets. Again, in aggregate they cannot obtain them without forcing up their currencies, though individual countries acting alone could do so.

In the end the only sure way to limit capital loss is to stop intervening and allow currencies to rise. The yen and Korean won have appreciated significantly since 2002. But while others remain pegged, such appreciation disrupts intra-Asian exchange rates and trade. The optimal solution is a co-ordinated revaluation, led by China. But while the Chinese economy thrives and inflation stays under control, Beijing has little incentive to agree.

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Prudent Investor says,

As editorial says, the recent gains of US dollar stands on tenuous grounds such that unconfirmed reports of Central Banks 'diversifying' away from the US dollar could provoke a dash to the exit doors. Currency volatility and the risk of a dollar run remains entrenched for as long as the structural imbalances exists. It surely does look as if Asian Currencies are the best bet in today's largely dicey environment.