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Testing, testing…. one, two, three
February 25, 2005

“Maybe it was all just a misunderstanding,” said the Wall Street Journal on Thursday after South Korea’s central bank denied reports that it may diversify its dollar-dominated foreign exchange reserves.

The dollar dropped to a seven-year low against the South Korean won on Tuesday after a single sentence in a thirty-two page report from the Bank of Korea to the National Assembly stated that it would “expand investment into non-government bonds, which have relatively higher yields, and diversify the currencies in which it invests.” The dollar fell 2 percent against the won and 1.4 percent against both the yen and the euro in response to the news and, as a result of the fall in the dollar, gold rose by about 1.7 percent in dollar terms.

Seoul quickly came out with a denial that they intend to sell any of their dollars, and the market stabilized.

The rapid decline in the dollar illustrates how nervous foreign exchange traders are about the greenback’s fundamentals. Any indication that foreign central banks will reduce their purchases of US Treasury securities ignites fears about the US budget and trade deficits. For most of last year I wrote about the twin deficits, explaining that the budget deficit puts upward pressure on interest rates and the trade deficit puts downward pressure on the dollar.

When the United States buys goods from China, Japan, South Korea, and others, it pays with US dollars. If these countries were not trying to keep the dollar strong -- and their own currencies weak relative to the dollar -- they would turn around and sell those same dollars into the foreign exchange markets. But they didn’t.

In order to keep the dollar strong, they used the dollars they received for their goods to buy US Treasury securities. This reduced the amount of dollars that would otherwise have flooded foreign exchange markets but it also caused serious distortions in their foreign exchange portfolios. China, Japan and South Korea together own just under one trillion dollars’ worth of US Treasuries.

It really doesn’t matter whether they sell any of their existing dollars or not. The US trade deficit is pumping hundreds of billions of additional dollars into their coffers every year. Even if these countries keep all the dollars they currently own but just not keep as high a percentage of the new dollars they continuously receive, the dollar will plummet.

There really isn’t any way around it. Either the dollar falls sufficiently to eliminate the trade deficit, or the trade deficit will continue to put pressure on the dollar.

Paul van Eeden

 


Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

Disclaimer

This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.


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