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February 24, 2005

Central Banks Are Diversifying? Of Course.

Brad Setser has several posts in the last few days -- here, here, and here -- noting the great excitement over a report that Korea plans to diversify its portfolio away from dollars.  There was this, from a Bloomberg report on Tuesday that Brad links to...

The dollar fell the most in more than a week against the euro and dropped versus the yen, Korean won and the Canadian and Australian currencies after the Bank of Korea said it plans to diversify its reserves.

South Korea's central bank, which has a total $200 billion in reserves, said in a report to a parliamentary committee on Feb. 18 that it will increase investments in assets denominated in currencies such as the Australian and Canadian dollars. Korean investors, including the central bank, are the fifth-biggest foreign holders of U.S. Treasuries.

... that included this breathless conclusion:

"Support for the dollar is quickly disappearing,'' said Kenichiro Ikezawa, who manages $1 billion in overseas debt at Daiwa SB Investments in Tokyo. ``This Korean story is having quite an impact because it feeds into suspicion that others are also seeking to cut their exposure to the dollar.''

Apparently, the Koreans (and others) weren't all that happy with that conclusion, as here is yesterday's news, from The Financial Express:

The dollar advanced in Europe after Japan’s ministry of finance and South Korea’s central bank said they have no plans to reduce US currency holdings. Taiwan’s bank said it hasn’t been selling dollars. The announcements by Japan, Korea and Taiwan, accounting for three of the world’s four largest currency reserves, came a day after the Bank of Korea sparked the biggest drop in dollar against the euro in more than six months by saying it planned to change the composition of its holdings.

The three central banks have a total of $1.26 trillion in reserves. ‘‘They’re trying to put out the fires caused by the comments on diversification on Tuesday,’’ said Toshi Honda, a currency strategist in London at Mizuho Corporate Bank, a unit of Japan’s biggest lender. ‘‘Today’s denials are having an impact and we’re seeing the dollar rebound.’’

I don't think the point is that diversification will not happen.  The point is that it is in everyone's interest for that adjustment to be orderly, that central banks intend to make it so, and that diversification will likely occur at the margin (that is, not in the form of widespread "dollar dumping").

I am on record as buying into the inevitability of an adjustment in U.S. current and capital account positions.  But I am not convinced by the doomsday scenarios, and the history of these things does not shake my confidence.

UPDATE: The picture of dollar reserve positions that orginally accompanied this post was WRONG, so I have removed it.  A follow-up will be forthcoming.

February 24, 2005 in Asia , Exchange Rates and the Dollar | Permalink


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I could not agree more with the view that central banks are not in the business of creating disorder. Perhaps one anecdote will suffice.

The time is late-late nineties. The Euro is about to be born, markets are awash with intellectual speculation regarding whether the Euro will become a major reserve currency overnight. I am thinking to myself, well, these European central banks, the Euro will become their national currency, right, so they are going to have to switch out of these old (converted into EUR) DEM's and buy USD or JPY(fat chance) as forex reserves. So I wonder, what about the currency composition of non-Europe Central Banks and, as Stalin might have suggested, who's got the heavy armor. The answer is at that time of course major oil producers and a very few Asians. I happen to meet privately with the "chairman" at, let's say, the least-unlikely-to-switch oil producer central bank. I put to him the market's theory that EUR will displace substantially the USD in forex reserves, ask for his opinion. He tells me "young man, look at me, do I look like I'm about to enter the olympic 100 yards race ?". He was, well, a rotund man, let's leave it at that.

Of course, now that North Korea has declared itself a nuclear power, South Korea, Taiwan and Japan can decide to do the US a favour and precipitate a USD crisis, but somehow I doubt it.

Posted by: Bernard Godement | February 24, 2005 at 08:40 AM

Orderly or not? time will tell.

But it is notable that the last time we needed an orderly adjustment we actually cooperated with the rest of the world in the Plaza and Louvre accords. Where is the cooperation now?

I am not a chicken little running aound saying that the sky will fall tomorrow. But the fact that we are even talking about the POSSIBILITY that the sky could fall is a testament to the incompetence of our economic and political leadership. This problem we are in is one we brought upon ourselves with irresponsible fiscal policy. We could fix it today by reversing the tax cuts of the past few years and knocking off the talk about borrowing $2 trillion to phase out Social Security - something that would go a long way toward convincing the markets that grownups were actually in charge over here.

Just such fiscal retrenchments were at the core of the agreements that led to the orderly adjustments in the 1980's. I see no sign of them now - in fact Bush is so widely hated in Europe and is so unilaterally arrogant that it is hard to imagine him actually able to make such an agreement. And it is that inability/unwillingness to use his political capital to do the right thing - and the right thing is to raise taxes to fix our budget hole - that makes it even possible to imagine a "disorderly" adjustment.

Posted by: steve kyle | February 24, 2005 at 09:04 AM

This is a fine post but I am more pessimistic and will argue a bit when I come away from philosophy land. Nice blog.

Posted by: anne | February 24, 2005 at 10:43 AM

The intriguing part of that chart is '87. An imperceptible blip in reserves accompanied a big, if transient blowoff in dollar asset values and lotsa lucrative volatility (which is now easier to exploit, and maybe intensify). Orderly adjustment is not incompatible with blood running in the streets.

Posted by: psh | February 24, 2005 at 12:48 PM

david -- could you provide a bit more detail on your data sources? I have not looked at the historical time series on reserve composition (imf annual report data may be the best source), but the graph looks funny to me. there is a srange spike in euro holdings/ dip in dollar holdings around 2000, and even ignoring that, the shift from say 30% of the overall reserve stock in dollars in 99-00 to say 70% in 2002 or 2003 seems a bit too big -- a shift of that magnitude in the overall composition of the stock would imply enormous flows out of euros and into dollars, and during much of 02-03 the euro was rising v. the dollar. I am also a bit surprised to see the dollar's share of global reserves dip so low in the mid 90s. It could well have happened, i have not looked at this data, but it "feels" a bit strange. in 1990s, every emerging economy in the world seemed to peg to the dollar for a while, including places like Russia. It is hard for me to link the data in the chart to a story about what was happening in the world, so I instinctively want to know more.

p.s. I misunderstood your post on my blog earlier today -- i thought you were referring to treasuries held abroad/ total treasury stock of marketable debt.

brad setser

Posted by: brad | February 24, 2005 at 04:00 PM

one other thought --

nouriel and i have argued that the number that really matters is the absolute increase in dollar debt held by central banks, since this generates the flows needed to finance ongoing deficits. obviously, this number can go up even if there is some diversification so long as the overall stock of reserves is rising rapidly. But i have trouble seeing how the US can get $400 b in net financing from central bank reserves if there is signficant diversification, even at the margins. The implied overall pace of reserve accumulation is just too high to be plausible.

So i would be interested in knowing a bit more about the financial flows that would accompany your orderly adjustment scenario -- assume say a 800b current account deficit in 05, 700 b in 06, 600 b in 07, and 500 b in 08 -- deficits of that magnitude imply significant ongoing external financing needs, even if the deficit is shrinking both absolutely and in relation to GDP. Presumably, you envision a gradual reduction in the pace of central bank dollar reserve accumulation that is combined with an increase in private flows, and presumably there is some gradual increase in uS interest rates that both slows the US economy (reducing import growth) and helps generate the needed private flows? Or am I putting words in your mouth?

Posted by: brad | February 24, 2005 at 04:07 PM

This article today makes it sound like the Asian banks will work together to support the dollar:
Morgan Stanley, ABN Amro Say Asia to Coordinate Currency Policy
Feb. 24 (Bloomberg) -- Asian policy makers will work together to try to stem the advance in their currencies against the U.S. dollar, said Morgan Stanley and ABN Amro Holding NV.


"Asian officials agreed on Feb. 22 to set up an organization called the Asian Bellagio Group to stabilize regional foreign-exchange markets, the Korea Times reported."

Bellagio? Isn't that the place for high stakes gambling?

Posted by: CalculatedRisk | February 24, 2005 at 09:05 PM

Great comments, all.

For Brad, specifically --

I'm away from the Bank (and the bulk of my resources) until Monday, but I'll send you the data when I get back. (That goes for anyone else interested, as well.) The blip that looks so funny comes about because the BIS data is monthly, and some wierdness happened right at the time of the switch to the euro. The IMF data is annual, so that stuff is washed out. And you are right that this trend is not nearly so apparent when you focus on total foreign holdings. (The BIS data looks very much like the IMF data on that score, as well it should.)

Posted by: Dave Altig | February 24, 2005 at 09:27 PM

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